What Role Do Rising Interest Rates Play in Inflation

What is the maximum rate of interest that could be raised?

If you’ve just gone food shopping or filled up your gas tank, you may have noticed that costs are rapidly increasing. If you’ve recently made a large purchase, such as a car, sticker shock may have been much more intense.

Consumers may be due for an even more nasty surprise in the form of rising interest rates. Interest rates have not yet fully adjusted to the current considerably increased rate of inflation, which is used to compute the amount you pay for borrowing money.

If interest rates adjust to inflation, borrowing costs for everything from credit card balances to mortgages might increase by several percentage points.

Credit Sesame looked into the relationship between interest and inflation rates over the last 25 years to see how high interest rates could go in this inflationary scenario. If interest rates return to a normal cushion over inflation, America might face double-digit auto loan and mortgage rates, as well as average credit card rates of more than 20%.

Inflation and Rising Interest Rates: What’s the Connection?

Inflation reduces the worth of money in the future. For instance, if prices double in the next 10 years due to inflation, a $1 today will be worth 50 cents in ten years.

When you lend someone money, you expect to receive at least the same amount back. Lenders make a living by lending money. They want to be paid a little extra (in the form of interest) in exchange for letting you utilise their money.

Lenders want the money they lend to have the same or more purchasing power when they get it back. As a result, they charge interest rates that are at least as high as inflation, plus a bit more to cover their risk and offer a profit margin.

Consider the amount that lenders charge over the rate of inflation as a safety net that guarantees lenders make a profit while also protecting them from risk.

Lenders modify their interest rates in response to changes in inflation, although these adjustments may be late. As a result, until lenders react, interest rates may be out of step with inflation

When comparing today’s inflation cushion to what it has been historically, you can get a sense of whether rising interest rates are out of whack.

What is the Definition of a Normal Inflation Cushion?

Credit Sesame used data from the previous 25 years to determine the size of a typical inflation cushion. It did so by analysing data from the Bureau of Labor Statistics, the Federal Reserve’s car loan, personal loan, and credit card rate data, and Freddie Mac’s mortgage rate data.

Remember that if a lender’s interest rates do not exceed inflation, the lender’s purchasing power will erode by the time the borrower repays the loan. As you can see from the graphic, vehicle loan rates, personal loan rates, credit card rates, and mortgage rates have all traditionally been higher than the average inflation rate (red).

However, inflation has recently risen substantially higher than the 25-year average of 2.26 percent, and lenders have failed to catch up. Inflation was 8.5 percent in the year ending March 31, 2022.

The green bars in the graph below represent average inflation buffers for the last 25 years. The yellow bars depict their current location. The inflation buffer built into interest rates is significantly smaller than average across the board. In other circumstances, it’s even the opposite. If these rates remain unchanged, lenders will lose purchasing power in the future.

Interest Rates Today with a Standard Inflation Cushion

Lenders aren’t going to accept an inflation cushion that is below average for long. They’ll be eager to get those cushions back into the positive. They’ll want to hike interest rates to avoid losing money and, more importantly, to make a profit.

What would it look like if interest rates rose in line with inflation like they usually do? To put it another way, how high would interest rates have to go to give a reasonable buffer above today’s inflation rate of 8.5 percent? The response is rather surprising. To provide a reasonable cushion against inflation, loan and credit card rates would have to climb substantially higher than they are now, with inflation at 8.5 percent.

A broad notion that the recent surge in inflation is temporary is one reason interest rates haven’t yet climbed to these levels. Inflation, on the other hand, is proving to be rather stubborn. The longer it lasts, the more lenders will raise rates to the levels depicted in the graph above.

What to Do and What Not to Do in a Rising Interest Rates Environment

Because no one has a crystal ball, it is impossible to determine whether inflation will continue to climb or remain stable. However, given the prospect of rates rising considerably above where they are now, here are some consumer dos and don’ts:

  • Don’t be hesitant to make large purchases. If you’re thinking about buying a house or a car that would require a large loan, you should make your decision as soon as possible. The longer you wait, the more likely rates will rise.
  • Pay off your debts. Over the past 25 years, interest rates have been extraordinarily low, indicating that it hasn’t been a bad time to be in debt. As lenders alter borrowing rates to increasing inflation, this might change dramatically.
  • Refinance or combine high-interest debt if possible. Even if interest rates rise, there are ways to lower your payments by transferring debt balances away from high-interest debt, such as credit cards. As typical credit card rates begin to rise, using lower-interest loans or zero-balance credit cards may be very beneficial.
  • Debt with a fluctuating interest rate is not a good idea. When interest rates are rising, debt that does not lock in a fixed rate is very risky. So stay away from variable-rate mortgages. While credit card issuers are limited in how they can boost rates on existing accounts, these balances tend to roll over quickly, meaning debt from new purchases gradually replaces debt from old balances as they are paid off. As a result, this would be excellent.
  • Shop around for the best deals. When interest rates were low, some people didn’t bother to search around for the best credit card and loan rates because the variations appeared to be minor. However, as interest rates climb, the stakes become bigger. In a fast-changing climate, you should expect more rate fluctuations because lenders react to rising inflation at various periods and to varying degrees.

Lenders have not yet caught up to today’s inflation climate, according to historical norms. They will, however, in the not-too-distant future. Consumers are the ones who are most likely to be caught off guard by significantly rising interest rates unless they change how they use debt.

Leave a Reply

Your email address will not be published. Required fields are marked *