Whenever you hear the latest inflation update on the news, chances are that interest rates are mentioned in the same breath.

In the United States, interest rates are decided by the Federal Reserve. The Fed meets eight times a year to set short-term interest rate targets. During these meetings, the CPI and PPIs are significant factors in the Fed's decision.

Interest rates directly affect the credit market (loans) because higher interest rates make borrowing more costly. By changing interest rates, the Fed tries to achieve maximum employment, stable prices and a good level growth. As interest rates drop, consumer spending increases, and this in turn stimulates economic growth. (To learn how trade currencies using these economic reports, read Forex Walkthrough: The Fed.)

Contrary to popular belief, excessive economic growth can in fact be very detrimental. At one extreme, an economy that is growing too fast can experience hyperinflation, resulting in the problems we mentioned earlier. At the other extreme, an economy with no inflation has essentially stagnated. The right level of economic growth, and thus inflation, is somewhere in the middle. It's the Fed's job to maintain that delicate balance. A tightening, or rate increase, attempts to head off future inflation. An easing, or rate decrease, aims to spur on economic growth.

Keep in mind that while inflation is a major issue, it is not the only factor informing the Fed's decisions on interest rates. For example, the Fed might ease interest rates during a financial crisis to provide liquidity (flexibility to get out of investments) to U.S. financial markets, thus preventing a market meltdown.

Next: Inflation: Inflation And Investments »



comments powered by Disqus
Trading Center