How Does Inflation Affect Interest Rates?

When prices rise, it can seem like borrowing costs rise right along with them. But is that really the case? How does inflation affect interest rates? We’ll have the answers to these questions and more.

Does Inflation Increase Interest Rates?

Inflation affects interest rates in two stages: The Federal Reserve (Fed) will raise short-term interest rates in an effort to control the money supply by making it more expensive to borrow. Because this lifts the cost of borrowing for banks, there’s a second stage where the increased cost is passed through to the client. Interest rates on consumer loans rise.

For certain types of loans, changes happen in advance of the Fed deciding. For example, after your mortgage closing, it’s common for the loan to finally be sold into the market 60 days later. Mortgage lenders try to predict the future based on Fed statements and market sentiment. The latter is important because rates shouldn’t be out of step with competitors.

There are a variety of reasons for inflation, the biggest outside of demand being supply chain issues. However, the only thing the Fed has influence over is the level of demand. It impacts this by making it more expensive to get your hands on cash, which has the effect of making people treat the money they do have in a more precious fashion. This decreases spending in hopes of bringing inflation to a more sustainable level.

In 2020, dealing with economic shutdowns related to COVID-19, the Fed dropped interest rates by 1.5% to near zero with the goal of making it cheaper for people to borrow, which encourages spending. This keeps people employed in making goods and services, so it worked as intended.

However, at the same time, the government gave a series of three stimulus checks to many Americans. This combined with low interest rates meant that people had more money in their pockets and were willing to spend it. Pretty soon, there came to be more demand than supply could keep up with. When people are willing to pay higher prices for limited goods and services, an inflationary cycle kicks in.

Now the Federal Reserve has pushed the Fed funds rate up 2.25% to a range of 2.25% – 2.5%. More increases are planned for the future until inflation reaches the Fed’s 2% target. Right now, annual inflation according to the Fed’s preferred metric is 4.6% as of this writing, excluding food and energy, but there’s a long way to go.

How Will Rising Interest Rates Impact Home Buyers?

As a general rule, when interest rates rise, you’re going to pay more for all credit and loans including mortgages. But let’s put some numbers to it.

If you had a previous 30-year fixed mortgage at 4%, your monthly payment would be $1,432.25 on a $300,000 loan. Assuming you don’t pay it off early, you would be paying $215,608.52 in interest over the loan term. Now let’s take that same loan amount and term and change it to 5.75%.

The monthly payment goes up to $1,750.72. In addition to the more than $300 monthly payment increase, you pay almost $115,000 more in interest. There are a few ways to think about this if you’re a home buyer.

If you can afford the monthly payment and a little extra, you can pay off your loan quicker and see serious interest savings. If you were to put just $100 per month extra toward principal, you save almost $50,000 in interest and pay off the loan 3 years, 10 months early.

On the other hand, if you don’t have the money to make that kind of payment with current interest rates you may be forced to look at cheaper houses. Some people might have to wait until rates come back down to buy. If you’re still able to make the payment at these rates, it could mean less competition. There are two sides to every coin.

What Causes Interest Rates To Rise With Inflation?

There are generally a couple of things that cause interest rates to rise with inflation. Let’s run through them.

Events And Uncertainty: Market And Psychological Forces

We live in a truly global economy. As such, there are all sorts of reasons the market might move in one direction or another without any intervention from the Fed. As an example, geopolitical instability can be a massive driver for market disruption. Western sanctions in response to Russia’s actions in Ukraine cut off a major source of oil for much of the world, particularly in Europe.

When there’s any kind of disruption to supply chains because of sanctions or natural disaster, this has the potential to move rates around as well as prices. Other things having an impact include elections. The president and Congress together have a major influence on fiscal policy and conditions in the economy, which influence rates and inflation.

There is also the fact that expectations create a self-fulfilling prophecy. If people anticipate that prices will continue to go up, they’ll be willing to pay more today in order not to have to pay as much tomorrow. However, if everyone thinks that way all the time, prices keep rising until the public reaches its breaking point.

All of these things happen independent of the Fed’s intervention and can have an impact on interest rates, moving them up or down. Before the Fed made any interest rate decisions, mortgage rates had been creeping up from record lows. In the first week of January 2021, the average 30-year fixed rate was 2.65%. The same time the following year, the rate was 3.22%.

The Fed: Government Intervention Through Monetary Policy

Monetary policy is control of a country’s money supply. In other words, is it easier or harder to access funds? In the United States, that’s the domain of the Federal Reserve.

The reason we care about how much money is in the economy is that if there’s too much, inflation can spin out of control. On the other hand, if money is hard to come by, you have a major warning sign for a recession because consumers and businesses will be hesitant to spend on goods and services that keep people in jobs.

The Fed controls the monetary supply by setting interest rates, specifically the federal funds rate. The federal funds rate is the interest charged when banks borrow money from each other overnight. Because banks pass through costs to their consumers, every rate offered by the bank is impacted by the federal funds rate.

In March 2020, when it wanted to encourage spending to keep the economy afloat during COVID-19, the Fed slashed the Fed funds rate to near zero. Housing is also a major part of the economy, so it bought mortgage bonds to help keep mortgage rates lower than they otherwise would be. We’ll have more on mortgage bonds in the next section.

Fast forward to this year. The Fed is ready to tap the brakes a little bit on the economy in response to elevated levels of inflation. They’ve raised the federal funds rate several times this year. With interest rates increasing, borrowing is more expensive. This encourages people to keep the money that they have in the bank, where they also earn a higher rate of interest.

If there’s more saving and less spending, prices should theoretically level off or even come down over time. That’s always the hope of the Federal Reserve and the federal government.

The Fed buying mortgage bonds kept demand for housing strong, but at the same time, higher and higher prices were supported by extremely low rates. The Federal Reserve has started to sell some of those bonds back into the market, which will have the effect of pushing rates higher.

How Are Mortgage Rates Affected By Interest Rate Increases?

Mortgage rates are determined both by movements in the market and your personal financial characteristics.

Mortgage rates are set based on the yield for mortgage bonds. A mortgage bond is made up of maybe 1,000 different mortgages. Which bond your mortgage ends up in depends on your qualifications. For example, there might be a conventional mortgage bond for people with 720 or higher credit scores and 10% down payments who are buying primary residences.

However, there’s another side to this, which is market demand for bonds. Bonds are considered a safe investment that pay back a consistent, if relatively low, rate of return. If people are feeling good about the economy, they tend to invest more in stocks, which are higher risk, higher reward. Economic uncertainty makes people lean toward bonds.

As mentioned earlier, the Federal Reserve has been a major buyer of mortgage bonds. Now that they’re selling bonds back into the market, rates are bound to rise. That’s the intention to slow inflation.

You cannot control the market for mortgage bonds, but the better your personal financial characteristics, the better your rate will be. Factors like a larger down payment or amount of existing equity make you a better candidate for lenders.

In addition to these, borrowers can also get a better rate by improving their credit score. Finally, for the best chance of approval, you’ll want to keep your debt-to-income ratio low, 43% or less.

The other way to protect yourself from rates bouncing around is to make sure you lock your rate as soon as you see one you like. A mortgage rate lock allows you to hold your interest rate for a certain period while completing the home loan process.

The Bottom Line: Inflation And Interest Rates Increase Together

Inflation leads to higher interest rates. However, the reason the Fed raises interest rates is to fight inflation, so it’s a trade-off. Higher prices to borrow or higher prices for everything.