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Inflation and interest rates tend to move in the same direction because interest rates are the primary tool used by the Federal Reserve, the U.S. central bank, to manage inflation.

The Federal Reserve Act directs the Fed, as it is often called, to promote maximum employment and stable prices. Since 2012, the Federal Reserve has targeted annual inflation of 2% as consistent with the stable prices portion of its dual mandate.

The Fed targets a positive rate of inflation, defined as a sustained rise in overall price level for goods and services, because a sustained decline in prices, known as deflation, can be even more harmful to the economy. The positive level of inflation and interest rates also provides the central bank with the flexibility to lower rates in response to an economic slowdown.

In August 2020, the Federal Reserve adopted average inflation targeting. That framework committed Fed policymakers to hold inflation above 2% for a time to compensate for stretches when the inflation rate fell short of that target.

Key Takeaways

  • Interest rates tend to move in the same direction as inflation but with lags, because interest rates are the primary tool used by central banks to manage inflation.
  • In the U.S, the Federal Reserve targets an average inflation rate of 2% over time by setting a range of its benchmark federal funds rate, the interbank rate on overnight deposits.
  • In general, higher interest rates are a policy response to rising inflation.
  • Conversely, when inflation is falling and economic growth slowing, central banks may lower interest rates to stimulate the economy.

How the Federal Reserve Measures Inflation

The Federal Reserve’s preferred inflation measure is the Personal Consumption Expenditures (PCE) Price Index. Unlike the Consumer Price Index (CPI), which is based on a survey of consumer purchases, the PCE Price Index tracks consumer spending and prices through the business receipts used to calculate the Gross Domestic Product (GDP).

The Fed also closely watches the core PCE Price Index, which excludes food and energy prices that are typically more volatile and tend to be less reflective of the overall price trend as a result.

How Changes in Interest Rates Affect Inflation

When the Federal Reserve responds to elevated inflation risks by raising its benchmark federal funds rate it effectively increases the level of risk-free reserves in the financial system, limiting the money supply available for purchases of riskier assets.

Conversely, when a central bank reduces its target interest rate it effectively increases the money supply available to purchase risk assets.

By increasing borrowing costs, rising interest rates discourage consumer and business spending, especially on commonly financed big-ticket items like housing and capital equipment. Rising interest rates also tend to weigh on asset prices, reversing the wealth effect for individuals and making banks more cautious in lending decisions.

Finally, rising interest rates signal the likelihood that the central bank will continue to tighten monetary policy, further tamping down inflation expectations.

Problems With Using Interest Rates to Control Inflation

As the chart above shows, policymakers often respond to changes in economic outlook with a lag, and their policy changes, in turn, take time to affect inflation trends.

Because of these lags, policymakers have to try to anticipate future inflation trends when deciding on rate levels in the present. Yet the Fed’s adherence to its inflation target can only be gauged with backward-looking inflation statistics. These can range widely amid economic shocks that can sometimes prove transitory and other times less so.

0.25 – 0.50%

The target federal funds rate announced by the Federal Reserve on March 16, 2022.

“In short, if making monetary policy is like driving a car, then the car is one that has an unreliable speedometer, a foggy windshield, and a tendency to respond unpredictably and with a delay to the accelerator or the brake,” former Federal Reserve chair Ben Bernanke said in 2004 while still a Fed governor.

Central banks trying to anticipate inflation trends risk making a policy error by needlessly stoking inflation with rates that are too low, or stifling growth by raising them.

In the case of the Federal Reserve, it must pursue its stable prices objective while also trying to maximize employment.

The Delicate Dance of Inflation and GDP

Interest Rates as a Monetary Policy Tool

The Federal Reserve uses the federal funds rate as its primary monetary policy tool. The federal funds rate, targeted as a range since 2008, is the overnight rate at which banks lend to each other over the very short term.

Traditionally, the Federal Reserve used open market operations—purchases and sales of securities—to adjust the supply of banking system reserves and hold the federal funds rate on target. Demand for reserves was the result of banking reserve requirements imposed to ensure the soundness of banks.

In the years following the 2008 global financial crisis, the focus of bank regulation shifted to capital buffer requirements and stress tests to ensure long-term solvency. In 2019, the Fed unveiled a policy of targeting the federal funds rate with two other rates it sets outright.

The interest on reserve balances (IORB) rate is what the Fed pays banks for overnight deposits in their Fed accounts. It sets an effective floor under the federal funds rate. Overnight reverse purchase agreements are a supplementary tool that pays a somewhat lower interest rate to non-bank money market participants for overnight deposits.

In 2020, the Federal Reserve eliminated reserve requirements for banks and other depository institutions.

The Bottom Line

Interest rates and inflation tend to move in the same direction but with lags, because policymakers require data to estimate future inflation trends, and the interest rates they set take time to fully affect the economy. Higher rates may be needed to bring rising inflation under control, while slowing economic growth often lowers the inflation rate and may prompt rate cuts.

The Fed targets a range of the federal funds rate, in part, by setting the rate it pays on banking reserve balances.

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