What is the effect of inflation on interest rates?

The relationship between inflation and interest rates is fundamental to understanding monetary policy and economics. When inflation rises, it typically leads to an increase in interest rates. This occurs because central banks, such as the Federal Reserve in the United States, respond to higher inflation by tightening monetary policy to control price levels.

Higher interest rates are a tool used to reduce inflation by making borrowing more expensive, thereby slowing down consumer spending and business investment. As the cost of borrowing increases, individuals and companies may delay or reduce their expenditure, which can help to temper inflationary pressures in the economy.

This dynamic is rooted in the concept of the Fisher effect, which states that nominal interest rates adjust to reflect inflation expectations. Consequently, as inflation expectations rise, lenders demand higher interest rates to compensate for the decreased purchasing power of money due to inflation over time.

Understanding this relationship is essential for anyone involved in investment management, as it influences not only bond markets but also stock valuations and overall economic stability. High inflation and rising interest rates can lead to decreased bond prices and can also negatively impact equity markets as expected future cash flows are discounted at higher rates.