I N F L A T I O N A N D I N T E R E S T R A T E S
* Taken Directly From: "Inflation: Inflation and Interest Rates." Adam Hayes, CFA for Investopedia. 13 Aug 2018
Inflation and interest rates are often mentioned in the same breath, and this is because the two are closely related. In the United States, baseline interest rates are set by the central bank, the Federal Reserve Bank. 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, because the Fed, as well as other major central banks, have a specific interest rate target in mind for the economy to achieve, usually 2-3% annually. This is known as inflation targeting. If inflation is the cost of saving money, interest rates are the cost of borrowing it.
Interest rates directly affect lending and borrowing because higher interest rates make servicing loans 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 which can spur inflation. The central bank also wants to keep growth in check, since excessive economic growth can in fact be quite 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 and can experience a deflationary spiral. 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.
Inflation targeting originated as an official policy in the late 1970’s with the Reserve Bank of New Zealand. The practice has since spread throughout much of the world. However, inflation targeting has come under fire over the past few years. First, despite inflation targeting, the rate of inflation has remained below its target in the U.S. for nearly every year since the Great Recession in 2008. Moreover, in Europe, they have even experienced deflation a few times over the past decade. A larger point is that the 2-3% inflation target, while it seems reasonable, is actually an arbitrary number with little to no empirical evidence that it is a valid level to target in the first place.
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.
Inflation is also related closely to unemployment. The Phillips Curve relates the inverse relationship between the two. The theory states that with economic growth comes inflation, which in turn should lead to more jobs and less unemployment. However, the original concept has been challenged empirically due to the occurrence of stagflation in the 1970’s when there were high levels of both inflation and unemployment. Economists have responded by allowing for many different Phillips Curves to exist, or by amending the relationship between inflation and unemployment to changes in the rates of inflation and unemployment.
* The Consumer Price Index (CPI) is a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food and medical care. It is calculated by taking price changes for each item in the predetermined basket of goods and averaging them. Changes in the CPI are used to assess price changes associated with the cost of living; the CPI is one of the most frequently used statistics for identifying periods of inflation or deflation.
** The producer price index (PPI) is a family of indexes that measures the average change in selling prices received by domestic producers of goods and services over time. The PPI measures price changes from the perspective of the seller and differs from the consumer price index (CPI), which measures price changes from the purchaser's perspective. The PPI considers three areas of production: industry-based, commodity-based and commodity-based final demand-intermediate demand. It was known as the wholesale price index, or WPI, until 1978.