How Does Raising Interest Rates Affect Inflation?

If high inflation strikes the American economy, high interest rates are likely to follow. Even though rising interest rates can make all types of financing — from credit cards to home mortgages to auto loans — more expensive, the (hopefully) short-term pain is worth it for the overall good of the economy. But what exactly is inflation, how does it work, and how do higher inflation and interest rates affect consumers and markets?

What Is Inflation?

Inflation is defined as the rise in the prices of goods and services in an economy, usually measured against prices from the previous year. According to Federal Reserve Chair Jerome Powell, “Without price stability, the economy does not work for anyone,” which explains the Fed’s mandate to squash inflation using aggressive measures, if necessary.

What Causes Inflation?

While there is no single cause of inflation, it’s ultimately triggered by an imbalance between supply and demand.

As the International Monetary Fund explains, long-lasting inflation results from an imbalance between the money supply and the size of the economy. An overabundance of money reduces its purchasing power and drives up prices. Inflation is the result.

An imbalance between the supply of goods and services and demand for those goods and services can also cause inflation.

A look at the real-world economy can help explain this phenomenon in more understandable terms.

Supply Chain Shortages

Global supply chain shortages made headlines throughout 2022. In particular, shortages in computer chips and other automobile parts slowed the production of cars. This created a shortage of autos, with the supply falling below the level of demand. As a result, car prices shot up in 2022, and many dealers charged sticker price or even more for their vehicles.

According to data from J.D. Power, auto prices were up 6.3% on a year-over-year basis as of September 2022. From February 2020 to September 2022, average used car prices shot up an astonishing 42.5%. These are examples of inflation at work.

Oil Price Increases

Another example of inflation in 2022 was the skyrocketing price of oil during the first half of the year. While global demand for the commodity had risen, the supply of oil had shrunk greatly, thanks in large part to the war in Ukraine. However, by June, concerns about inflation reduced demand for oil, and prices gradually declined.

How Does the Fed Measure Inflation?

Most Americans, and even most news outlets, measure inflation via the consumer price index, more popularly known as the CPI. But the Fed relies instead on the Personal Consumption Expenditures price index, also referred to as the PCE price index. One of the main differences between the two is that the PCE is a chained index, while the CPI is not. For many economists, this makes the PCE more accurate at representing price changes across time and items. The goal of the Fed is to keep the long-term increase in the PCE at 2% per year.

What Effect Do Rising Rates Have on Inflation?

Rising interest rates tend to slow the growth of inflation. One way to describe inflation is “too much money chasing too few goods.” If either the supply of goods increases or the amount of consumption declines, inflation tends to level out, or even decline. While rising interest rates can’t help the supply of goods and services, they tend to decrease the level of consumption — sometimes dramatically.

As with most economic principles, this one can make more sense when placed in a real-world perspective. Here are some examples.

Car Loans

Imagine you’re looking to take out a 60-month loan to buy a car with $0 down and a total cost of $40,000. With a 2.9% interest rate, you’ll be looking at a monthly payment of $716.97, and the total cost of your loan will be $43,018.29. But if interest rates are 6.9% instead, that monthly payment will rise to $790.16, and your total cost will skyrocket to $47,409.73. That’s more than $4,000 just in additional interest costs.

Mortgage Loans

Things get even worse when it comes to mortgage loans. A $350,000, 30-year mortgage at 3.9% results in monthly payments of $1,650.84 and a total loan cost of $594,301.94. But the same mortgage at a 7.5% interest rate results in monthly payments of $2,447.25 and a staggering total loan cost of $881,010.28. That’s approximately a 50% increase in monthly payments and an additional $285,000-plus in pure interest you’ll be paying on that loan.

The point of these examples is that these increased costs are enough to drive some potential buyers out of the home and auto markets. This is the literal definition of “reduced consumption,” which can help reduce inflation. When fewer people are buying houses and cars, prices tend to moderate. This is the goal of monetary policy during inflationary times — raising interest rates to the point that demand falls, pulling down inflation rates with it.

What Are the Risks of Rising Rates?

Rising rates are harmful to American consumers who use credit, and they also pose a risk to the American economy as a whole. While in theory raising rates tames inflation, the reality is that it’s an inexact science.

The truth is that there is a lag between when the Fed raises rates and when the increases actually affect the economy, and it’s easy to overshoot the target. And if the Fed raises rates for longer than it should, it generally tips the economy into recession. A severe recession can be equally as harmful to the economy as runaway inflation, and if a recession tips into a depression, things can become even worse.

How Do Rising Rates Help Savers?

Although rising interest rates can be harmful to the economy — and to individual consumers — they are actually beneficial for savers. When the Fed raises interest rates, banks increase the rates they pay on savings accounts. For example, during the heart of the pandemic, when the Fed dropped interest rates to essentially zero, most savings accounts paid little to nothing, with some banks offering a meager 0.01%. Now that rates have been steadily rising, savings rates at most online banks are over 4%. On a $20,000 balance, that boosts interest paid from about $2 per year to more than $800.

How Do Rising Rates and Inflation Affect the Stock Market?

Although rising interest rates help individual savers, when combined with rising inflation, they act as a major drag on the stock market. Both high inflation and high interest rates negatively impact corporate earnings. High inflation makes everything that companies buy more expensive, and high interest rates increase the cost for businesses to take out loans. For highly leveraged companies that rely on loans to fund their operations, high interest rates could imperil their very existence. As a result, investors tend to pull their support for these types of companies, hurting their share prices.

How Do Rising Rates and Inflation Affect Consumers?

Purposely raising interest rates may seem like a purposely harmful act against the American consumer. After all, how can it help anyone if they have to pay higher rates for things like homes, vehicles and even credit cards? The answer is that the alternative — runaway inflation — harms everyone with continually rising prices. But higher interest rates can be avoided, at least temporarily, if consumers delay purchases that require loans, such as homes or vehicles. Paying off credit card debt — or avoiding it in the first place — is another way that consumers can sidestep rising interest rates.

Inflation, on the other hand, can be harder to avoid. Even the most frugal of consumers must purchase everyday goods like food and medicine, and when prices are rising, that leaves less money for discretionary expenses, savings or even other necessities. On a personal level, both rising interest rates and inflation are harmful to household budgets.

The Bottom Line

In and of themselves, both high interest rates and high inflation are overall negatives for both American consumers and businesses. High interest rates make any type of borrowing less affordable, while high inflation makes the prices of goods and services rise as well. When combined, these factors can bust the budgets of everyday Americans and make it harder for companies to generate profits — or even to stay in business. But if the Fed can succeed in taming inflation by raising rates, the long-term health of the economy will be preserved.

The main risk in this scenario is that the Fed continues to tighten rates until it strangles the economy and pushes it into recession. However, as soon as inflation falls to more desirable levels, the Fed typically reverses course and may even begin lowering interest rates, kicking off the next cycle of business growth. When — and if — that will happen during this current business cycle, however, is unknown at this point.

Daria Uhlig contributed to the reporting for this article.

This article originally appeared on GOBankingRates.com: How Does Raising Interest Rates Affect Inflation?