Inflation and Interest Rates: What’s the Link?

These two conversations are connected—but what’s the link between inflation and interest rates, and what is the impact on your personal finances? 

The short answer is that when inflation is high, the Federal Reserve—the central bank of the U.S.—often raises interest rates to encourage less spending and to keep prices steady. If the economy slows down, Fed policymakers may lower rates to decrease borrowing costs and help encourage spending activity. 

Keep reading to learn more about the connection between interest rates and inflation, and how they may affect you.

What is inflation?

Inflation is a measure of how quickly the prices of goods and services increase over time. Higher inflation means that consumer prices are rising relatively quickly, while a lower inflation rate means that prices are increasing more slowly.

What causes inflation? 

A lot of things can contribute to rising inflation, including higher costs for raw materials or wages and greater consumer demand. For example, recent news about tariffs and trade wars could end up affecting the inflation rate; changing tariffs on imported goods and materials can impact prices and consumer confidence.

Inflation may also be affected by things the government does that encourage people to spend more, like initiating tax cuts and lower interest rates

What are interest rates?

An interest rate is the amount a lender charges to lend a borrower money. Interest on a loan is typically paid back in installments over the loan’s repayment term as part of the regular payment schedule. The interest rate is usually expressed as a percentage amount.

Why do interest rates rise when inflation is high?

One of the goals of the Federal Reserve is to keep the annual inflation rate at about 2%. 

The Federal Open Market Committee—a group of fed policymakers—meets eight times a year to discuss monetary policy and set the target interbank interest rate, also called the “federal funds rate.” This rate determines what banks charge to borrow money from each other, which then affects what your bank charges you to borrow.

When inflation is too high, the Fed may raise interest rates to encourage consumers and businesses to spend less.

Inflation becomes a problem when it is so high it exceeds wage growth and when it is unpredictable. Both of these can make it difficult for consumers and businesses to plan.

How do higher interest rates lower inflation?

When the Federal Reserve raises interest rates, it increases the cost of borrowing money. As a result of a higher interest rate, people may try to spend less and thus the demand for products may decrease. This lack of purchasing power may help stabilize prices, which limits inflation.

On the other hand, when there is a rate cut, it costs less for consumers and businesses to borrow money. This may make it more affordable for people to make bigger purchases, like buying a car or paying for a home, or to borrow money through other loans, creating more economic activity. Lower interest rates may lead to more hiring in the labor market and a lower unemployment rate.

What is the difference between fixed and variable interest rates?

There are two basic types of interest rates: fixed and variable.

Fixed interest rates

As the name suggests, a fixed interest rate means the rate will not change for the duration of the loan or for a set amount of time. A fixed interest rate is typically not affected if the Fed raises or lowers interest rates.

One benefit of a fixed-rate loan is that you know in advance how much the overall cost of borrowing will be. With an installment loan, for example, you have one set regular monthly payment and know precisely when the loan will be paid off.

Variable interest rates

On the other hand, the interest rate on a variable-rate loan may rise and fall throughout the duration of the loan. This may change the amount of interest you pay for the money you borrowed and your overall borrowing cost.

For example, if market changes lead to a higher interest rate on your variable-rate loan, and your minimum monthly payment remains the same, less of your payment would go toward paying down the principal. This would mean it may take you longer to pay off your debt and end up being more expensive. 

What are some ways to help combat rising interest rates?

There are many ways you can help protect your finances against the impact of interest rate changes, higher inflation, and borrowing cost increases. 

For example, if you’re considering a new loan, keep in mind that the interest you pay might increase if you choose a variable-rate loan. Instead, applying for a fixed-rate loan, such as a personal loan, might help you better plan your financial future.

If you already have a variable-rate loan or line of credit, like a credit card, consider moving that debt to a fixed-rate loan. By consolidating variable-rate debt into one fixed-rate loan, you could save money on interest and even pay off the debt faster. In fact, 89% of surveyed debt consolidation customers told us they expect to pay off existing debt sooner with a Discover® personal loan.*

To see how much you might save on interest with a fixed-rate loan and one set regular monthly payment, you can use our debt consolidation calculator. 

A fixed-rate personal loan for a purchase or debt consolidation might also simplify your finances and help you reach your financial goals. Over 3 million people have reached their goals with a Discover personal loan.

Want to check your interest rate on a Discover personal loan with no impact to your credit score?

Articles may contain information from third parties. The inclusion of such information does not imply an affiliation with the bank or bank sponsorship, endorsement, or verification regarding the third party or information.

**ABOUT SURVEY

All figures are from an online customer survey conducted in September 2024. A total of 736 Discover personal loan customers were interviewed about their most recent Discover personal loan with 546 of them using the funds to consolidate debt. All results @ a 95% confidence level. Respondents opened their personal loan between January and July 2024 for the purpose of consolidating debt. Agree includes respondents who ‘Somewhat Agree’ and ‘Strongly Agree’. For debt consolidation, even with a lower interest rate or lower monthly payment, paying debt over a longer period of time may result in the payment of more in interest.