5 Ways Inflation Impacts Interest Rates

As the Federal Reserve raised interest rates by half a percentage point, many Americans are wondering how this move affects their wallets.

This increase puts the federal funds rate at nearly 1%, up from 0.33%—the highest level since March 2020.

The Bureau of Labor Statistics (BLS) announced in May 2022 that consumer prices increased 8.3% for the year ending in April 2022. Prices at restaurants and for meals eaten away from home were up almost 7% from the previous year, while grocery prices increased 10%, according to the U.S. Department of Agriculture.

The Fed anticipates the federal funds rate will reach 1.9% by the end of 2022 and 2.8% by the end of 2023. That may not sound like much, but it can significantly affect consumer spending and borrowing.

Fed Chairman Jerome Powell’s goal in implementing the largest single rate increase since 2000 is to fight inflation without triggering a recession. There are already signs—in the cooling housing market and volatile stock prices—that this task will prove difficult. The 30-year mortgage rate is already approaching 5% as home prices cool across multiple metro areas.

To explain how these changes trickle down to everyday household budgets, we’ve compiled five ways inflation affects interest rates. Data sources include the Federal Reserve, Reuters, and The New York Times.

1. Higher Interest Rates

Driven in part by rising housing, food, and energy costs, the U.S. Department of Labor says the current inflation rate is the highest recorded in 40 years.

The Federal Reserve has historically increased the federal funds rate to curb high inflation. For example, the federal funds rate reached 20% in 1980 as inflation soared following the energy shocks of the 1970s.

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2. Lower Interest Rates

During historic periods of low inflation, the Fed has lowered the federal funds rate.

Following the dot-com bust in the early 2000s, the Fed reduced rates to below 1% over concerns about potential deflation.

As former Fed Chairman Ben Bernanke explained in a 2010 speech:

“Taking note of the painful experience of Japan, policymakers worried that the United States might sink into deflation and that, as one consequence, the FOMC’s target interest rate might hit its zero lower bound, limiting the scope for further monetary accommodation.”

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3. Consumer Loans

When the Fed changes the federal funds rate, borrowing costs for consumer loans—including mortgages, auto loans, and credit cards—generally change as well.

During periods of high inflation and rising interest rates, this can reduce demand for consumer products as well as homes, vehicles, and other big-ticket purchases that are commonly financed.

By making borrowing more expensive, higher interest rates can also slow consumer demand and economic growth.

4. Savings Accounts

Rapid inflation decreases the real return earned on savings accounts.

This effectively devalues money held in banks, encouraging capital to flow into financial markets and real estate. Inflation has also pushed some investors toward more volatile or speculative assets, such as cryptocurrencies and non-fungible tokens (NFTs).

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5. Impact Lag

The Federal Reserve often lags behind inflation when setting interest rates.

In an attempt to anticipate inflation, the Fed may adjust the federal funds rate before inflation gets out of hand. However, pandemic-fueled government spending, along with higher food, fertilizer, and animal feed costs stemming from the Russia–Ukraine war, suggests elevated prices may persist for months to come.