The Federal Reserve, who has been hiking interest rates, has been in the news recently. In this blog post, I will talk about the relationship between interest rates and inflation. Inflation is the increase in prices and the fall in purchasing value of money. In other words, inflation is the reason why a 24 pack of coca cola in 2008 was $5.48, and in 2018, it was $7.68.
The Federal Reserve controls inflation by either increasing or decreasing interest rates. For the past couple of years, the Federal Reserve has been increasing interest rates. What does this mean for inflation? Rising interest rates makes borrowing money difficult, which lowers economic growth and causes slower inflation. The Federal Reserve has to ensure that it hikes interest rates appropriately, since rapid interest rate hikes could lead to deflation. Deflation is the reduction of general level of prices in the economy. In other words, under deflationary pressure, the 24 pack of coke selling at $7.68 in 2018 could sell for $5.50 in 2020. Deflation is not good for the economy because it incentivises people to save money, rather than to spend it. Why wouldn’t you want to save money if you can buy more with $1 tomorrow than what you can buy with that same $1 today? As people start spending less, monetary circulation in the economy decreases, which slows down the economy. As the economy slows, companies report lower earnings, manufacturing decreases, unemployment increases, etc. So, the Federal Reserve has to be very careful when they are increasing interest rates. Now, what happens to inflation when the Federal Reserve cuts interest rates? As the Federal Reserve cuts interest rate, it makes borrowing money easy, which leads to higher economic growth and faster inflation. This previous sentence should make sense. Since companies can borrow money (at little to no interest), the money circulating in the economy increases, which grows the economy; as the economy grows, wages would increase; as the cost of labor goes up, it would cause prices of goods to increase (inflation). So, when the Federal reserve decreases interest rates, inflation increases. The last time Federal Reserve cut interest rates was during the great recession of 2007-08 in order to jump start the US economy. Interest rates and the rate of inflation are inversely related.
It is important to have inflation under control. The last thing you want is to have your 24 pack of coca cola selling at $7.68 in 2018, then selling at $30.25 in 2020, and then selling at $5.25 in 2022. Federal Reserve targets an inflation of 2%. So, the Fed will increase (or decrease) interest rates to maintain the 2% inflation target.
Hope you learned a little and found this blog post helpful. We talked about how the interest rates and inflation are related. We saw that as one goes up, the other goes down. As always, you can sign up for our mailing list here. Like us on our Facebook page here. Thank you!
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