Inflation and interest rates are linked,
and frequently referenced in macroeconomics. Inflation refers to the rate at
which prices for goods and services rises. In the United States, interest rates
– the amount of interest paid by a borrower to a lender – are set by the Federal
Reserve (sometimes called "the Fed"). In general, as interest rates
are lowered, more people are able to borrow more money. The result is that
consumers have more money to spend, causing the economy to grow and inflation
to increase. The opposite holds true for rising interest rates. As interest
rates are increased, consumers tend to have less money to spend. With less
spending, the economy slows and inflation decreases.
The Federal Open Market Committee (FOMC)
meets eight times each year to review economic and financial conditions and
decide on monetary policy. Monetary policy refers to the actions taken that
affect the availability and cost of money and credit. At these meetings,
short-term interest rate targets are determined. Using economic indicators such
as the Consumer Price Index (CPI) and the Producer Price Indexes (PPI), the Fed
will establish interest rate targets intended to keep the economy in balance.
By moving interest rate targets up or down, the Fed attempts to achieve maximum
employment, stable prices and stable economic growth. The Fed will tighten
interest rates (or increase rates) to stave off inflation. Conversely, the Fed
will ease (or decrease rates) to spur economic growth.
Investors and traders keep a close eye on
the FOMC rate decisions. After each of the eight FOMC meetings, an announcement
is made regarding the Fed's decision to increase, decrease or maintain key
interest rates. Certain markets may move in advance of the anticipated interest
rate changes and in response to the actual announcements. For example, the U.S.
dollar typically rallies in response to an interest rate