What is the relationship between inflation and interest rates?

By Jean Folger AAA
A:

Inflation and interest rates are linked, and frequently referenced in macroeconomics. Inflation refers to the rate at which prices for goods and services rises. In the United States, interest rates – the amount of interest paid by a borrower to a lender – are set by the Federal Reserve (sometimes called "the Fed"). In general, as interest rates are lowered, more people are able to borrow more money. The result is that consumers have more money to spend, causing the economy to grow and inflation to increase. The opposite holds true for rising interest rates. As interest rates are increased, consumers tend to have less money to spend. With less spending, the economy slows and inflation decreases.

The Federal Open Market Committee (FOMC) meets eight times each year to review economic and financial conditions and decide on monetary policy. Monetary policy refers to the actions taken that affect the availability and cost of money and credit. At these meetings, short-term interest rate targets are determined. Using economic indicators such as the Consumer Price Index (CPI) and the Producer Price Indexes (PPI), the Fed will establish interest rate targets intended to keep the economy in balance. By moving interest rate targets up or down, the Fed attempts to achieve maximum employment, stable prices and stable economic growth. The Fed will tighten interest rates (or increase rates) to stave off inflation. Conversely, the Fed will ease (or decrease rates) to spur economic growth.

Investors and traders keep a close eye on the FOMC rate decisions. After each of the eight FOMC meetings, an announcement is made regarding the Fed's decision to increase, decrease or maintain key interest rates. Certain markets may move in advance of the anticipated interest rate changes and in response to the actual announcements. For example, the U.S. dollar typically rallies in response to an interest rate increase.

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