The Effect of Interest Rates on Inflation & Unemployment

by Karen Gardner; Updated June 26, 2018
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When you hear interest rates mentioned, you probably don't get too excited. But interest rates really are a vital barometer of the American economy – they affect what we all have in our bank accounts. Interest rates go up and they go down. These changing interest rates can jump-start economic growth and fight inflation. This, in turn, can affect the unemployment rate. The Federal Reserve Bank, commonly known as the Fed, doesn’t dictate interest rates, but it can affect our financial future because it sets what's known as monetary policy. It does this through the federal funds rate, which controls interest rates.

Affecting our Financial Future

The Fed’s biggest influence on our pocketbooks and our overall financial condition is to cause the federal funds rate to go up or down. This rate, often called the benchmark rate, is the interest rate banks charge each other for short-term loans. Changing this rate has a bit of a domino effect on the market. Banks and lending institutions will pass on these higher or lower rates. That means it may cost you more or less to borrow, whether for your household or a business. It will affect the interest you are charged for mortgage and business loans. The benchmark rate also affects a few other things, such as corporate bond rates; equity prices; and the foreign exchange value of the dollar. All of these can combine to affect overall U.S. economic activity.

What Interest Rate Changes Mean

When short-term interest rates drop, it becomes cheaper to borrow money to fix up your house or buy a car. It’s also cheaper for companies to spend money to expand their businesses. Buying equipment or property become cheaper, and more companies are willing to take the plunge. But if it looks like inflation will go up in the near term, interest rates will start to rise. Higher interest rates may mean higher mortgage rates, which, in turn, could actually cause home prices to tumble.

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What Increased Spending Does

Extra spending spurred by lower interest rates helps companies hire more employees to handle the growth in business. When businesses hire more workers and increase production, people have more money in their pockets and are more likely to spend it. All this takes a little time to show up in the economy, but with more people spending money, unemployment rates tend to drop even more. Lower interest rates can spur companies to update their plants and equipment and train workers, boosting investment in the company.

Effects of Stronger Demand

With lower unemployment and businesses feeling confident enough to expand, this stronger demand for goods and services helps to push wages and other costs higher. Workers have more choices in jobs and they ask for more money. More companies want supplies and materials to make more items or provide more services, and that higher demand allows suppliers to charge more. It's kind of like a circle. We want more spending, but not too much, because all that spending could lead us toward higher prices. If prices keep rising, we get what many economists and politicians dread – inflation.

Background on Inflation

The U.S. has had mostly low inflation since the double-digit increases of the 1970s. The Fed's policy of tinkering with the benchmark interest rate helped to tighten the amount of money being spent, which helped to slow inflation starting in the 1980s. In order for this to happen, however, the U.S. had to go through a period of recession and high unemployment. There was a time when unemployment hit 10 percent.

We had more recessions in the early 1990s and early 2000s, and a major recession in 2008, but the U.S. never went back to that runaway inflation period. In January 2012, nearly four years after the economic downturn of 2008, the Fed decided that inflation should be at about 2 percent to keep the economy healthy. For at least five years following that policy decision, inflation remained below that target.

Setting the Benchmark

The three core principles that the Fed sticks to when it decides to change that benchmark rate are: inflation rate, unemployment rate and changes in gross domestic product, or GDP. That's the total output of the U.S. economy. Although an increase in GDP growth could spur the Fed to increase the benchmark interest rate, an increase in unemployment would likely slow down the process. The Fed’s objectives are maximum employment, stable prices and moderate long-term interest rates.

About the Author

Karen Gardner is a former features editor and reporter, and is now a freelance writer in Maryland. She enjoys writing about business for the rest of us.

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