PennyWorks explains five ways inflation affects interest rates set by the Federal Reserve.
5 ways inflation affects interest rates
5 ways inflation affects interest rates
While the Federal Reserve has raised interest rates by half a percentage point, many Americans wonder how the move affects their wallets.
This increase puts the federal funds rate at almost 1% from 0.33% – the highest level since March 2020. The Bureau of Labor Statistics (BLS) announced in May 2022 that consumer prices had risen by 8.3% for the year ending April 2022. . Prices for restaurants and meals eaten away from home rose by almost 7% compared to last year, while food prices rose by 10%, according to the US Department of Agriculture.
The Fed expects the federal funds rate to reach 1.9% by the end of 2022 and 2.8% by the end of 2023. This may not sound like much, but it can significantly affect consumer spending and lending. Fed chief Jerome Powell’s goal in raising rates by the largest single rate increase since 2000 is to fight inflation, but without causing a recession. In a cold housing market and volatile stock prices, there are signs that this task will be difficult. The mortgage rate for 30 years is already pushing 5%, as house prices are cooling in several meters.
To explain the different ways this gets into everyday household budgets, PennyWorks has compiled a list of five ways inflation affects interest rates. Data sources include the Federal Reserve, Reuters and The New York Times.
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Higher interest rates
Partially driven by the spiraling costs of housing, food and energy, the Department of Labor says the current US inflation rate is the highest in 40 years. The Federal Reserve has historically raised the rate of federal funds to curb high inflation. The federal funds rate reached 20% in 1980 as inflation rose sharply in the 1970s after energy shocks.
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Lower interest rates
In historical periods of low inflation, the Fed has reduced the rate of federal funds. After the dot-com slump in the early 21st century, the Fed cut it below 1% due to fears of possible deflation. “Given Japan’s painful experience, policymakers feared that the United States could fall into deflation and that, as a result, the FOMC’s target interest rate could reach zero, which would limit the scope for further monetary accommodation,” the former chief said. Fed Chairman Ben Bernanke in a speech in 2010.
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Consumer loans
When the Fed changes the rate of federal funds, it means that rates on consumer loans – mortgages, car loans, credit cards, etc. – will also increase. During periods of high inflation and interest rates, this can have an impact on demand for consumer products, as well as on houses, cars and other large ticket purchases that people fund.
By making products on credit or lending at higher interest rates less attractive, high inflation can also slow demand and economic growth.
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Savings accounts
Rapid inflation reduces “real” interest rates earned on savings accounts. This ends in the devaluation of money deposited in banks, which drives capital into financial markets and real estate. Inflation has also driven investors into more volatile or speculative assets, such as cryptocurrencies and unmistakable tokens.
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Impact delay
The Fed often lags behind inflation in setting interest rates. In an effort to anticipate changes in inflation, the Fed could adjust the federal funds rate before inflation gets out of control. But thanks to government spending over the pandemic and higher food, fertilizer and animal feed costs from the Russo-Ukrainian War, rising prices will continue in the coming months.
This story originally appeared on PennyWorks and was produced and distributed in collaboration with Stacker Studio.
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