When it comes to interest rates, most people only understand how they impact them. They think about their mortgage rate or the APR on their car loan.
There is much more to interest rates, however, and how they relate to and impact the overall performance of the economy.
Namely, the direct tie between interest rates and inflation.
Inflation is when the supply of money exceeds the demand for money. A higher supply of money means more money in circulation, devaluing the dollar. This causes consumer prices to rise.
A rise in inflation spurns buying, as consumers expect prices to rise. Therefore, buying now guarantees a better deal than waiting to buy later.
Inflation fluctuates on a yearly basis. In the United States, inflation is at a five-year low, clocking in at 1.3% as of August.
Higher inflation is good for economies looking for growth. Inflation would be good for the current economy which is recovering from the loss of jobs and spending due to coronavirus.
The Federal Reserve, the central banking system of the United States, helps control inflation in two ways: raising or lowering expectations of future inflation and altering interest rates.
The Fed recently announced plans to keep rates near zero at least through the end of next year, with some rates staying there until 2023. They have also targeted an inflation goal of 2% for that time period. If inflation runs below 2%, rates will stay low until inflation runs “moderately” above 2% for an extended period of time.
These plans could play a huge role in the recovery of the U.S. economy, especially if unemployment rates contract to where they were pre-COVID.
While low interest rates attract individuals and businesses to seek loans for a mortgage, auto purchase, or growth opportunities, inflation encourages debtors to pay off their debts. As inflation grows, the money debtors pay back is worth less than the money they borrowed.
Of course, inflation is not only a good thing. It has its downsides, too. Inflation is the reason a gallon of gas costs 10 times what it cost 90 years ago. Wages rise to match inflation, but extended periods of inflation that exceed 2% means the average consumer spending a higher percentage of their earnings.
While putting the pandemic behind us does not mean an immediate recovery in the labor market and economy as a whole, it does put us on the road to getting there. With lower rates and higher inflation, we should get there sooner.