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How inflation & interest rates are related: A simple explanation

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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.

While higher inflation and rising interest rates present potential challenges, you can navigate these hurdles by learning what's going on behind the scenes. With the connection between inflation and interest rates in mind, you could better visualize how these forces may impact your savings and investments—and the overall performance of your financial assets.

How inflation is measured & tracked

Inflation is measured and tracked using economic indicators and price indices:

  • 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 long and variable lag time of 12–18 months for higher interest rates to begin working through the economy and for inflation to begin normalizing.

Lenders and investors typically demand higher interest rates to protect the real value of their investments. This is because, with higher interest rates, they can earn a return that compensates for the eroding effect of inflation on their money's future value. This means mortgages and credit cards have higher rates, and fixed-income investments like bonds have higher yields.

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 savings accounts and CDs, as well as yields for bonds, would fall.

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.

A financial advisor can help you make investing decisions during periods of high or low inflation. They can talk through different strategies for investing during inflation and offer advice around coping emotionally with inflation, all while keeping your longer-team financial plan in mind.

CDs offer a fixed rate of return. The value of a CD is guaranteed up to $250,000 per depositor, per insured institution, by the Federal Deposit Insurance Corp. (FDIC). An investment in a money market fund is not insured or guaranteed by the FDIC or any other government agency. A money market fund seeks to maintain the value of $1.00 per share although you could lose money. The FDIC is an independent agency of the U.S. government that protects the funds depositors place in banks and savings associations. FDIC insurance is backed by the full faith and credit of the United States government.