Kavan Choksi: How Interest Rates Affect Inflation

Kavan Choksi: The Inflation-Interest Rates Link

Inflation and interest rates typically move in the same direction because interest rates are the main tool used by the Federal Reserve to fight inflation. The Federal Reserve Act directs the Fed to stabilize prices and promote maximum employment. Since 2012, the Federal Reserve has had a 2 percent inflation rate target consistent with the stable prices portion of its mandate, Kavan Choksi explains.

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The Federal Reserve adopted a new framework called average inflation targeting (AIT) in 2020. Fed policymakers aim to hold inflation above 2 percent for some time to compensate for stretches when the inflation rate falls short of that target.

When the Federal Reserve counters inflation risks by raising its benchmark federal funds rate, it also increases the level of central bank reserves in the financial system, limiting the supply of money available for purchases of risk assets. Conversely, when a central bank decreases its interest rate target, it effectively increases the money supply available to purchase riskier assets.

Kavan Choksi says rising interest rates discourage consumers and businesses from spending, especially on big-ticket items such as capital equipment and houses, by raising borrowing costs. Rising interest rates also typically weigh on asset prices, reversing the wealth effect for people and making banks more hesitant to lend money. Finally, rising interest rates may force the central bank to continue to tighten its monetary policy, tamping down inflation expectations.

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Policymakers typically take some time to respond to changes in the economic outlook, and the necessary policy changes, in turn, also take some time to affect inflation. Because of these lags, policymakers tend to try to predict future inflation trends when deciding on rate hikes in the present. Yet backward-looking inflation statistics can only measure the Fed's adherence to its inflation target. These can vary widely amid economic shocks that can sometimes prove transitory and other times less so.

In short, making monetary policy is like driving an old car, says Kavan Choksi. The car has an unreliable speedometer, a foggy windshield, and a delay to the accelerator or the brake.

For more insights and updates on investing, business, and economics from Kavan Choksi, visit his blog site. Click this link to access the blogs.