Interest Rates and Inflation: What Do They Really Mean?

Interest rates and inflation are two very important financial indicators in the U.S. economy, and it is important to understand the basics.

When you hear the phrase – “interest rate hike” or “the Fed is raising rates” – the rate being referred to is the Federal Funds Rate.

The Federal Funds Rate is the interest rate that banks charge each other when lending excess cash from their reserve balances on an overnight basis. This rate is determined by the Federal Open Market Committee during their eight regularly scheduled meetings per year. It is one of the factors that can influence short-term rates on consumer loans and credit cards.

The Federal Reserve often increases interest rates to dampen rising inflation and slow the economy. As the cost to borrow increases, what you can afford to purchase decreases, meaning spending goes down. If spending goes down, demand also goes down, which most often results in decreasing prices at the gas pump or grocery store. This, in turn, helps to slow inflation.

The opposite is also true. Decreasing interest rates typically help promote economic growth. As the cost to borrow decreases, we as consumers are likely to purchase more, which ultimately stimulates our economy.

So why is it important to dampen rising inflation and slow the economy in the current market?

Inflation, by definition, is a general increase in the prices of goods and services in an economy. When we see higher prices at the gas pump or at the grocery store for example, each dollar you have in your pocket purchases fewer goods. In other words, inflation is directly correlated to a decrease in the purchasing power of money.

The Federal Reserve has historically aimed for an inflation rate of 2% over the long-term. When actual inflation deviates from that target, the Fed can utilize tools like changes in interest rates to bring inflation back to target.

We at Boulay Financial Advisors are here to simplify the complex. Reach out to us if you would like to learn more from a wealth management advisor.