WTF is Going on With Inflation and Interest Rates?
Blog | June 7th, 2022
It seems like all anyone is talking about these days is inflation. For months now, food and gas prices have been rising every day. For some mysterious reason, it will cost more money this year to buy the same things you bought last year–when those things were already expensive.
The rising prices beg the question: WTF is going on with inflation and interest rates? It may seem confusing and overwhelming at first, but we’re going to break it down into bite-sized pieces that are easier to digest. Let’s find out what inflation is and why it affects us.
What is Inflation?
So, what exactly is inflation? It’s the rate that prices increase over a certain amount of time due to the value of money decreasing. In straightforward terms, it’s how much you can buy with $1 today. When our currency loses value, the less we can buy less, so prices rise.
For example, a movie ticket cost an average of $2.89 in 1980, while in 2019, a movie ticket cost an average of $9.16. So if you had $10 in 1980, you could buy three tickets, but if you had $10 in 2019, you could only buy one.
Usually, we look at inflation in terms of years, but you can choose other amounts of time. In addition, we typically look at it in broad terms, such as the general cost of living. But you can also look at specific things like how much tomatoes cost, the price of a haircut, or the price of the movie ticket mentioned earlier.
Many factors go into determining the value of money, like the demand for it and international exchange rates, so the inflation rate changes all the time.
The basic formula for determining inflation is (current price – former price)/former price.
CPI: Annual inflation rates are calculated using the CPI, which gets its data from the Bureau of Labor Statistics. It’s considered the inflation benchmark in the United States. It tracks the changes in costs of eight major categories.
PPI: The Bureau of Labor Statistics publishes the PPI as well. It shows the changes in prices that companies face due to increased taxes and rising gas prices.
PCE: This rate is published by the Bureau of Economic Analysis. It shows how much consumers spend each month across the board instead of focusing on specific things. It’s the Federal Reserve’s preferred method.
All three of these rates are necessary for a complete understanding of the inflation rate, but each one shows us a lot on its own. The CPI is updated monthly. At the time of writing this article, the U.S. rate is 8.5%, the highest it’s been since 1981.
The PPI is up 1.4% for goods and 2.3% for services, and the PCE is up 6.6%. These data allow us to see increases across the board, though consumers are bearing the brunt of it so far.
A bit of inflation is actually healthy for the economy as it encourages spending rather than saving. Still, this amount is too high to be sustainable. The ideal rate of inflation is 2%.
How Has It Increased So Rapidly Recently?
The most likely reason why inflation has increased so rapidly recently is COVID-19. The beginning of the pandemic interrupted supply chains globally and significantly affected the U.S. labor force. So, fewer goods and services were available, yet demand remained the same, if not higher.
At the same time, a large quantity of new money was introduced into the economy in the form of stimulus checks. Having more bills in print did not mean that there was actually more money circulating in the economy, so the dollar’s value decreased.
Now that lockdowns have ended and people are returning to normal spending levels, there’s an even higher demand for goods and services. All three of these factors have combined to create an exceptionally high inflation rate in a short amount of time.
How Are Interest Rates Affected?
Interest rates are negatively affected by inflation. As inflation rates rise, so do interest rates because lenders try to offset the devaluation of the money they’re lending out.
If you take out a loan for $1000 and only repay $1000, the lender could technically lose money if the value of that money decreases during the period in which it takes you to repay it. It all has to do with supply and demand.
What Has the Fed Done in Hopes of Bringing Down Inflation?
The Federal government has some control over both inflation and interest rates. They have taken some steps to bring down inflation, though perhaps not enough, as they didn’t think it would stay high for so long.
To discourage people from borrowing money, the Fed raised interest rates by the most significant margin in over 20 years. They are considering two more increases soon as well. The idea is that if it costs more money to borrow money, fewer people will want to borrow money.
This is a risky move because it could stall economic growth or even result in an economic recession. And, none of the rates acknowledge the fact that inflation does not affect everyone equally. The longer high inflation rates continue, the harder it is on poor people who have to dig into their savings, if they even have any, just to make ends meet.
There’s a lot more involved in inflation and interest rates than you may have previously thought, but that doesn’t mean it’s too difficult to understand. We’ve broken these concepts down into smaller, more digestible pieces that have hopefully cleared some things up for you.
It also may feel like there’s not much we can do to combat inflation, but that’s not entirely true either. There are ways to protect yourself against inflation that are easier to accomplish at home. Try your best, and don’t get discouraged. Economics is always cyclical; eventually, what went up must come down.