Interest rate trajectory with changing inflation

A lined graph showing interest rates and inflation rates from 2005 to 2024

The Federal Reserve uses interest rates as one of the many monetary policy tools to keep inflation at 2% and ensure full employment.

Here’s how the terms in this relationship typically work:

  1. Fed Funds Rate: The interest rate at which depository institutions (banks and credit unions) lend reserve balances to other depository institutions overnight on an uncollateralized basis. It’s essentially the rate at which banks borrow money from each other to meet their reserve requirements.
  2. Inflation: Inflation refers to the rate at which the general level of prices for goods and services is rising, eroding purchasing power. Central banks, including the Federal Reserve, aim to keep inflation at a moderate and stable level, often targeting a specific inflation rate.

The relationship between the two can be summarized as follows:

  • Tightening Policy: When inflation is rising above the central bank’s target or is expected to rise significantly, the Federal Reserve may implement a tightening monetary policy. This often involves increasing the federal funds rate. By raising interest rates, borrowing becomes more expensive, leading to reduced spending and investment. This, in turn, can help to cool down inflationary pressures.
  • Easing Policy: Conversely, when inflation is below the central bank’s target or economic conditions are weak (such as during a recession), the Federal Reserve may implement an easing monetary policy. This typically involves lowering the federal funds rate. Lower interest rates make borrowing cheaper, encouraging spending and investment, which can help stimulate economic activity and push inflation toward the central bank’s target.
  • Expectations: In addition to the current inflation rate, expectations about future inflation also influence the Federal Reserve’s decisions regarding the federal funds rate. If businesses and consumers expect inflation to rise or remain high, the Fed might act preemptively to raise interest rates to prevent it from spiraling out of control.

Lag Effect: Changes in the federal funds rate don’t immediately impact inflation. There’s often a lag between changes in monetary policy and their effect on the economy. It might take several months to years for changes in interest rates to fully influence inflation.