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    How Do Higher Interest Rates Bring Down Inflation?

    Our columnist is responding to readers’ questions. This week, he focuses on inflation, with the help of a bond maven and a Nobel laureate.

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    Inflation & Interest Rates Relationship Explained

    Inflation and interest rates are linked, but the relationship isn't always straightforward.



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    How to Profit From Inflation

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    Core Inflation Headline Inflation RELATED TERMS (A-I) GDP Price Deflator Indexation

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    What Is the Relationship Between Inflation and Interest Rates?

    By JEAN FOLGER Updated May 05, 2022

    Reviewed by MICHAEL J BOYLE

    Fact checked by TIMOTHY LI

    Inflation and interest rates tend to move in the same direction because interest rates are the primary tool used by the Federal Reserve, the U.S. central bank, to manage inflation.

    The Federal Reserve Act directs the Fed to promote maximum employment and stable prices.1 Since 2012, the Federal Reserve has targeted annual inflation of 2% as consistent with the stable prices portion of its dual mandate.

    The Fed targets a positive rate of inflation, defined as a sustained rise in the overall price level for goods and services, because a sustained decline in prices, known as deflation, can be even more harmful to the economy. The positive level of inflation and interest rates also provides the central bank with the flexibility to lower rates in response to an economic slowdown.2

    In August 2020, the Federal Reserve adopted average inflation targeting. That framework committed Fed policymakers to hold inflation above 2% for a time to compensate for stretches when the inflation rate fell short of that target.3


    Interest rates tend to move in the same direction as inflation but with lags, because interest rates are the primary tool used by central banks to manage inflation.

    In the U.S, the Federal Reserve targets an average inflation rate of 2% over time by setting a range of its benchmark federal funds rate, the interbank rate on overnight deposits.

    In general, higher interest rates are a policy response to rising inflation.

    Conversely, when inflation is falling and economic growth slowing, central banks may lower interest rates to stimulate the economy.

    The Fed plans to continue raising interest rates in 2022 in order to curb the highest rates of inflation in 40 years.

    How the Federal Reserve Measures Inflation

    The Federal Reserve's preferred inflation measure is the Personal Consumption Expenditures (PCE) Price Index. Unlike the Consumer Price Index (CPI), which is based on a survey of consumer purchases, the PCE Price Index tracks consumer spending and prices through the business receipts used to calculate the Gross Domestic Product (GDP).4

    The Fed also closely watches the core PCE Price Index, which excludes food and energy prices that are typically more volatile and tend to be less reflective of the overall price trend as a result.

    How Changes in Interest Rates Affect Inflation

    When the Federal Reserve responds to elevated inflation risks by raising its benchmark federal funds rate it effectively increases the level of risk-free reserves in the financial system, limiting the money supply available for purchases of riskier assets.

    Conversely, when a central bank reduces its target interest rate it effectively increases the money supply available to purchase risk assets.

    By increasing borrowing costs, rising interest rates discourage consumer and business spending, especially on commonly financed big-ticket items like housing and capital equipment. Rising interest rates also tend to weigh on asset prices, reversing the wealth effect for individuals and making banks more cautious in lending decisions.

    Finally, rising interest rates signal the likelihood that the central bank will continue to tighten monetary policy, further tamping down inflation expectations.5

    Problems With Using Interest Rates to Control Inflation

    As the chart above shows, policymakers often respond to changes in economic outlook with a lag, and their policy changes, in turn, take time to affect inflation trends.

    Source : www.investopedia.com

    Here's a look at inflation

    The view that higher rates help stamp out inflation is essentially an article of faith, based on long-held economic gospel. But how does it really work?


    Here’s how the Fed raising interest rates can help get inflation lower, and why it could fail



    Federal Reserve policymakers are going to try to slow down the economy and subdue inflation.

    Higher rates make money costlier and borrowing less appealing. That, in turn, slows demand to catch up with supply, which has lagged badly throughout the pandemic.

    Fed officials also have talked tough on inflation, in an effort to dampen future expectations.

    Potential effects include lower wages, a halt or even a drop in home prices and a decline in stock market valuations.

    A customer shops at at a grocery store on February 10, 2022 in Miami, Florida. The Labor Department announced that consumer prices jumped 7.5% last month compared with 12 months earlier, the steepest year-over-year increase since February 1982.

    Joe Raedle | Getty Images

    The view that higher interest rates help stamp out inflation is essentially an article of faith, based on long-held economic gospel of supply and demand.

    But how does it really work? And will it work this time around, when bloated prices seem at least partially beyond the reach of conventional monetary policy?

    It is this dilemma that has Wall Street confused and markets volatile.

    In normal times, the Federal Reserve is seen as the cavalry coming into quell soaring prices. But this time, the central bank is going to need some help.

    “Can the Fed bring down inflation on their own? I think the answer is ‘no,’” said Jim Baird, chief investment officer at Plante Moran Financial Advisors. “They certainly can help rein in the demand side by higher interest rates. But it’s not going to unload container ships, it’s not going to reopen production capacity in China, it’s not going to hire the long-haul truckers we need to get things across the country.”

    Still, policymakers are going to try to slow down the economy and subdue inflation.

    The approach is two-pronged: The central bank will raise benchmark short-term interest rates while also reducing the more than $8 trillion in bonds it has accumulated over the years to help keep money flowing through the economy.

    Under the Fed blueprint, the transmission from those actions into lower inflation goes something like this:

    The higher rates make money costlier and borrowing less appealing. That, in turn, slows demand to catch up with supply, which has lagged badly throughout the pandemic. Less demand means merchants will be under pressure to cut prices to lure people to buy their products.


    The Fed can’t escape the need for tough policies to combat inflation, says Komal Sri-Kumar

    Potential effects include lower wages, a halt or even a drop in soaring home prices and, yes, a decline in valuations for a stock market that has thus far held up fairly well in the face of soaring inflation and the fallout from the war in Ukraine.

    “The Fed has been reasonably successful in convincing markets that they have their eye on the ball, and long-term inflation expectations have been held in check,” Baird said. “As we look forward, that will continue to be the primary focus. It’s something that we’re watching very closely, to make sure that investors don’t lose faith in [the central bank’s] ability to keep a lid on long-term inflation.”

    Consumer inflation rose at a 7.9% annual pace in February and probably surged at an even faster pace in March. Gasoline prices jumped 38% during the 12-month period, while food rose 7.9% and shelter costs were up 4.7%, according to the Labor Department.

    The expectations game

    There’s also a psychological factor in the equation: Inflation is thought to be something of a self-fulfilling prophecy. When the public thinks the cost of living will be higher, they adjust their behavior accordingly. Businesses boost the prices they charge and workers demand better wages. That rinse-and-repeat cycle can potentially drive inflation even higher.

    That’s why Fed officials not only have approved their first rate hike in more than three years, but they also have talked tough on inflation, in an effort to dampen future expectations.

    In that vein, Fed Governor Lael Brainard — long a proponent of lower rates — delivered a speech Tuesday that stunned markets when she said policy needs to get a lot tighter.

    It’s a combination of these approaches — tangible moves on policy rates, plus “forward guidance” on where things are headed — that the Fed hopes will bring down inflation.

    “They do need to slow growth,” said Mark Zandi, chief economist at Moody’s Analytics. “If they take a little bit of the steam out of the equity market and credit spreads widen and underwriting standards get a little tighter and housing-price growth slows, all those things will contribute to a slowing in the growth in demand. That’s a key part of what they’re trying to do here, trying to get financial conditions to tighten up a bit so that demand growth slows and the economy will moderate.”

    Source : www.cnbc.com

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