Inflation Update: How Do Rising Interest Rates Affect Inflation?

It might be hard to see, but rate hikes are already having an effect.

Inflation hasn’t cooled off this year, and neither has the pressure for central banks to raise benchmark interest rates to help tame rising costs. By raising the cost of borrowing, policymakers hope to cool consumer demand and prevent prices from increasing even more. 

Central banks in many regions started raising rates earlier this year, but inflation rates have continued to rise. Have the rate hikes really had any effect? 

“I feel like there has been an impact,” said Chris Atkins, C2FO’s president of capital finance and markets. “It’s true that inflation is still growing, but we’ve started to see signs that it may not be growing as fast. And some sectors, like apparel and used cars, are definitely seeing improvement.

“But just as importantly, the Fed and other policymakers are sending a message to the market. They’re not going to stop raising rates until inflation eases to target rates, and that is leading other players, including banks and other investors, to take important action now.”

The C2FO Outlook

According to C2FO’s proprietary data model, which harnesses hundreds of million invoices on its platform, the Consumer Price Index (CPI) is projected to have increased by 8.4% year-over-year (YOY) in May while the Producer Price Index (PPI) is estimated to have grown by 11.7%. 

C2FO can estimate changes to the CPI and the PPI, two key measures of inflation, more than a week before the US Bureau of Labor Statistics. The agency will release its official update on May CPI on June 10 and on May PPI on June 14.

What the central banks say is as important as what they do

When it comes to interest rates, it’s important to look at what actions have been taken so far — and what central banks are saying they’ll do in the future. 

US

The Federal Reserve is expected to increase the federal funds rate by half a percentage point at its June 15-16 meeting, following a similar hike in May. That May increase, the largest in 20 years, moved the Fed’s target rate range to 0.75% to 1%. 

According to minutes from the Fed’s most recent meeting, hikes of 50 basis points are possible in July and September, too. This forecast is important because the Fed is signaling that it will not stop acting until it sees a path to desired inflation targets.

Canada

The Bank of Canada raised rates by a half-percentage point in April to 1% and is poised to do so again during its meeting in June — and potentially July and September, too. 

UK

In early May, the Bank of England approved a rate increase of 25 basis points to 1%, its fourth increase since December. And the bank is ready for another increase. 

EU

(Not everyone is raising rates, though. China lowered a key rate in an apparent effort to boost its real estate sector. In April, sales of new homes there were down 47% compared to a year prior.)

Clearly, all these rate increases have not solved the inflation problem. But the Fed and other central banks have signaled to investors that, if inflation continues at elevated levels, the central banks will keep raising rates. Capital will become more expensive and less available. 

“The Fed has given them the map,” Atkins said. “They said, ‘We’re going to keep doing this until inflation comes down.’”

That’s one reason the stock market has taken such a beating in recent weeks. Investors are looking ahead six to eight months, and they don’t like the volatility and likely lower earnings that they see. They’re pulling back because equities are less interesting in that expected future market than in the past.

That, in turn, leads businesses that were accustomed to relatively cheap and easy money to tighten up their operations. They might delay expansions, freeze hiring or even lay off employees. All of those steps help reduce overall demand in the market, further suppressing inflation. 

Interest rate hikes could reduce access to bank loans

So far, the Fed’s rate hikes have totaled about three-quarters of a percentage point, taking the prime rate from roughly 3.25% to 4%. (The prime rate is typically 300 basis points higher than the federal funds rate.)

“Three-quarters of a percent might not seem like a huge increase, but interest is now 23% more expensive than a year ago,” Atkins said.

Add in tightening amortization and other inflating costs, and suddenly, borrowers that looked like good risks one year ago are going to have a harder time securing loans. Together, increased borrowing costs and lower debt service ability will have the effect of reducing lending availability and borrowing attractiveness.

And that should also help reduce inflation because businesses won’t have as much money to spend, easing demand. 

What you can do now: Look for financing that interest rates can’t touch

Rate hikes might be necessary for the larger economy, but they could also disrupt the ability of some companies to borrow funds when necessary — a potentially business-ending condition.  

“If you’re a bank borrower and you’re kind of on the bubble, you need to start cultivating nonbank relationships,” Atkins said. 

The bottom line

Ultimately, the Fed and the other central banks are looking for a glide path from the current situation where, each month, inflation has shown an increase of 8% to 10% on a year-over-year basis.

Instead, they’re gradually raising interest rates so that they can see a path where inflation will lessen from 8% to 7% to 6% and on to targets of around 3%.

Personally, Atkins expects the Fed will raise the federal funds rate by a half-percentage point this month, but increases in July and September might just be a quarter-percentage point. 

It all depends on what happens next with inflation. 

“They have not hit that glide path yet,” Atkins said. “The central banks are going to continue to punch really hard until inflation reduces significantly and hits a path they’re comfortable with.”