How inflation & interest rates are related: A simple explanation

At this point, you likely know inflation has been hitting historic highs worldwide. In the U.S., a gauge known as the Consumer Price Index (CPI) indicates that consumer prices rose 9.1% from June 2021 to June 2022—the largest 12-month increase in 40 years. Supply shortage fallout from the COVID-19 pandemic and higher energy prices, driven in part by Russia's invasion of Ukraine, contributed to this astounding CPI rise. Many suppliers haven't been able to keep up with consumer demand due to issues such as labor shortages and supply chain disruptions.

And it's not just inflation that's increased—both inflation and interest rates have moved sharply higher, which is no coincidence.

Generally speaking, modern economic theory suggests that inflation is driven by supply and demand. Rising inflation indicates there is more demand than supply for goods and services, which are increasing in price.

The Federal Reserve has tools to help control inflation if it's showing signs of persistence.

One such mechanism is raising the federal funds rate, which is the interest rate that banks charge each other for lending or borrowing reserve balances overnight. This benchmark interest rate directly or indirectly influences other interest rates, including rates for credit cards, car loans, student loans, mortgages, certificates of deposit and savings accounts.

The Fed's recent interest rate hikes have been directed at curbing the demand side of the supply-and-demand interplay. The theory is that the higher interest rates will deter some consumers and businesses from spending on homes, cars, remodels and other large purchases that might require a line of credit or some other form of taking on debt. With higher interest payments, the purchase would be more expensive and therefore less attractive for buyers, slowing down demand.

It may take time for the Fed's rate hikes and other moves—such as reducing securities holdings—to bring down inflation to its generally "acceptable" 2% target.

In the meantime, the Fed is busy analyzing economic data, including trends in prices and wages as well as consumer expectations about inflation over time, to determine how much to raise rates and how frequently. It's a delicate task since hiking rates can solve one problem while causing many others.

Because consumer spending represents approximately two-thirds of U.S. GDP, increasing interest rates and thereby reducing consumer spending too much can contribute to a recession—which is a significant, far-reaching decline in economic activity lasting more than a couple of months.

One historical example that serves as a cautionary tale is the 1981-82 recession, a dreary period during which the unemployment rate hit nearly 11%. It came on the heels of inflation peaking at 11.6% in March 1980 (the CPI was 14.8%) and the Fed boosting the federal funds rate to a record high of 20% months later. The painful medicine of high interest rates worked, however. Inflation dropped to 5% by October 1982 and the labor market improved.

Even if raising rates doesn't have such dramatic consequences, any intended cooling of economic activity can have negative repercussions for workers. The International Monetary Fund, for example, expects that reduced demand could push the U.S. unemployment rate to about 5% by the end of 2023, which should in turn cause wages to fall.

Climbing rates can have ripple effects on consumers' finances that go beyond layoffs and lower wages.

Consider 30-year fixed-rate mortgages, which aren't directly tied to the federal funds rate but generally move in the same direction. Higher mortgage rates could spook potential buyers and lead sellers to reduce the asking price of their homes, which is already happening in some markets. Other consequences of higher interest rates are more direct, like increases in the cost of borrowing. There's a good chance your credit card's annual percentage rate could rise following a rate hike, for example. That jump may make it even more critical to pay off monthly balances in full to avoid paying interest altogether.

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.

It's important to try as best as you can to wisely manage your finances during this volatile and confusing period. However, sometimes you might need a little help.

If you've been putting off a large purchase that simply can't wait any longer, or if you can't pay your credit card bills and you're concerned about the mounting interest, you might want to reach out to a financial advisor. These professionals can help you learn more about inflation and interest rates, and help you create a strong financial plan, no matter what you're looking to accomplish. They can help you plot out the best path forward to weather this storm.