Changes in inflation can go hand in hand with changes in interest rates, and that trickles down to your investments. Interest rates often move a step behind inflation, but generally in the same direction.
How inflation is measured & tracked
- The Consumer Price Index (CPI) is the most widely recognized measure of inflation. It tracks changes in the prices of a basket of goods and services that the typical consumer would regularly purchase. Items in this basket include food, clothing, housing, transportation and medical care.
- The Producer Price Index (PPI) measures the average change in prices that producers receive for their goods and services over time.
- The Personal Consumption Expenditures (PCE) Price Index is similar to the CPI but tracks a broader range of prices. The Federal Reserve uses it for its inflation targeting.
When the Federal Reserve is trying to fight inflation with various tools, such as raising interest rates, they will track these inflation measures to determine how well those tools are working.
The relationship between inflation & interest rates explained
Inflation and interest rates are closely connected because changes in inflation can influence the level of interest rates in an economy. When inflation rises, the purchasing power of a currency decreases, which means that the same amount of money buys fewer goods and services. To help fight inflation, the Federal Reserve can raise interest rates, which discourages borrowing and slows economic activity. Generally, you see a
Lenders and investors typically demand higher interest rates to
In contrast, when inflation is low, interest rates tend to be lower as well, as there's less urgency to compensate for diminishing purchasing power. When inflation decreases rapidly, the Federal Reserve may decide to lower rates to stimulate the economy.
How does deflation affect interest rates?
Deflation means that prices for goods and services are falling, which is the opposite of inflation. A deflationary environment is harmful to the economy. In reaction, the Federal Reserve would lower interest rates to boost economic activity.
In a deflationary, falling rate environment, interest rates on a range of debt instruments, such as mortgages, auto loans and credit cards, also would fall. This would help to stimulate the economy by making the cost of borrowing lower, leaving room in consumers' budgets to spend more. However, rates on interest bearing accounts, such as
How does decreasing inflation, or disinflation, affect interest rates?
Decreasing inflation, also called disinflation, means that prices for goods and services are still rising, but they're rising at a lower rate over time. Disinflation is not always associated with a change in interest rates. For example, if inflation is high, as it was in 2022 and 2023, falling inflation will not cause the Federal Reserve to lower interest rates until reaching a certain threshold, such as 2%.
Therefore, disinflation in itself may not translate into a falling interest rate environment unless inflation is already low and the Fed feels that the economy is in danger of entering into deflation.
Reach out for guidance on your investments
While higher interest rates can be costly for borrowers, the opposite may be true for savers. Yields on certificates of deposit (CDs), savings accounts, money market funds and bonds generally rise when the Fed raises interest rates, putting more money into the pockets of savers or investors. Therefore, when possible, it's wise to maintain a balance of low debt levels and high savings rates during periods of high inflation and high interest rates.