Interest rates, said a prominent economist, are like the relative who always shows up at every family affair. “You just take him for granted and hardly notice how he looks or feels.” Interest rates go up or down, but most people hardly take notice, except for those who happen to be in a transaction where interest rates matter. A young couple that just put together a down payment on a first house and applied for a mortgage might take notice. So are all the businesses that depend on the interest rate to make their money, like the banks and other financial institutions.
But if ever there was a time when interest rates matter it is a time like this when the inflation rate in the US is expected to reach 7.20 percent by the end of this quarter. We as consumers are feeling it at every turn, whether at the gas pump or at the supermarket. It has become a painful reality that inflation is not about to end anytime soon. Depending on the economist you listen to it is only a question of how many more years it will persist.
Naturally, although we focus on such basic items like food, gas, and household supplies, inflation will affect interest rate levels. The higher the inflation rate, the more interest rates are likely to rise. This occurs because lenders will demand higher interest rates as compensation for the decrease in purchasing power of the money they are paid in the future. So much depends on that lending rate that it has a trickle-down effect on almost anything we buy.
In the U.S., the interest rate (which is the amount charged by a lender to a borrower) is based on the federal funds rate that is determined by the Federal Reserve. The Federal Reserve System is the central bank of the U.S.; it is sometimes just referred to as the Fed. In general, when interest rates are low, the economy grows, and inflation increases. Conversely, when interest rates are high, the economy slows, and inflation decreases. So where are we now?
Despite our record-setting inflation, interest rates remain relatively low. On the surface this should mean a bonanza for the economy. People are able to borrow money and finance luxury items like automobiles and houses. When people can borrow money and yes, using credit cards is borrowing money, they tend to spend more which is a major infusion for the economy. With today’s dominating entities like Amazon, people are borrowing unprecedented amounts to finance their lifestyle and the convenience on-line shopping offers. But at the same time, it has resulted in unprecedented credit card usage.
Consumers have watched inflation spike prices relentlessly, particularly on the basic necessity items like fuel and food. When interest rates go up, consumers behave entirely differently. The minute they are able to get a decent return on their money, they’d rater keep the money in the bank than spend it. There is a direct correlation between interest rates and the way we behave economically.
In the past year, even as inflation has soared, credit growth has also been remarkable despite very low interest rates Real household debt has increased just 2.2% annualized since the pandemic began while business borrowing is growing at the slowest pace in eight years, even after businesses loaded up on cheap pandemic loans early in 2020. Businesses, it seems, have made other adjustments so that they do not have to borrow heavily. They have trimmed their personnel, cut back on production, and even closed unproductive plants.
For our young couple looking to buy a house, they would be advised to lock in a rate because of the uncertainty where inflation is headed instead of a flexi-rate. Housing starts, which is always a measure of the strength of the economy, was a bit sluggish in 2021. According to official figures, the 2021 median sales price for a house was $370,000 which marks a 19.4-percent increase over 2020’s $310,000 price. Inventory plummeted 30.4-percent to close out 2021. Homes for sale fell to only 30,654 units in December 2021 compared to 44,071 homes available in December 2020. People are holding on to their houses in this post-Covid inflation ridden era.
Another measure closely tied to interest rates and inflation is unemployment. When people aren’t working, they aren’t spending disposable income and inflation is possibly choking them. The labor market is down 3.6 million jobs from pre-pandemic levels. The labor-force participation rate is down 1.5 percentage points, and not all of the people who’ve dropped out are willing retirees. More than 12 million people are either looking for work or would like to work if they could.
We learned during the pandemic that even if people don’t work, if they somehow have access to money, they will borrow and purchase more goods. Real disposable personal incomes soared during the pandemic from stimulus checks, tax and debt relief, and unemployment payments, but per-capita real incomes are now running at a level just 1.9% higher than when the pandemic began.
Interest rates and inflation are definitely intertwined. Almost every time we make a purchase nowadays, we are burrowing and there is an interest rate attached to the borrowing. The Fed knows very well that in some measure it controls the economy. It has the power to manipulate interest rates which in turn have a direct effect on what we buy and how we purchase. It also knows that if it raises interest rates it is playing into the rate of inflation.
Watching interest rates is important for everyone because it dictates our quality of life. If we can borrow with a low rate, we can afford to buy luxury items and spend more on travel, automobiles, and other goods that we desire.
Some economists say that to end inflation will mean controlling the pandemic and helping the economy adjust to a new normal. We will need to strengthen and shorten our supply chains for the inevitable next wave or next pandemic. We need significant investments in new domestic and global supply capacity, including manufacturing and transportation. Above all, it means luring back millions of potential workers who are put off by bad, unsafe, and low-paying jobs. They agree that higher interest rates won’t help us make those adjustments.