High interest rates & inflation: What that means for you

You may hear reports from time to time that inflation is still high, and you probably notice it in the prices you're paying at the store. Inflation may be down from its 2022 peak of 9.1%, but it's been a slow decline.

That can prompt some important questions: What do higher interest rates mean for you, your household and the people you care for? What do high rates mean for the country? For the future?

The good news is the effects aren't all negative. To get to the bottom of those questions, let's take a look at how rising interest rates and inflation are linked, how they impact your money (and the broader economy) and ways you can take advantage of the effects.

The relationship between interest rates and inflation can be complex, but one straightforward influence is action taken by the Federal Reserve and other central banks that control the money supply.

To cool down high inflation, the Fed increases its federal funds rate, which is the interest rate banks charge each other for lending or borrowing reserve balances overnight. This rate directly and indirectly influences other interest rates, including the ones set by financial institutions for both lending and saving by consumers—everything from credit cards, car loans and mortgages to CDs and savings accounts.

These higher interest rates make it more expensive to borrow money, which usually leads to less consumer spending and business investment.

Inflation is often caused by an increase in demand for goods and services that outpaces the available supply. Rising demand can lead to higher prices as consumers compete for limited resources. When the Fed raises interest rates, it's aiming to reduce consumer spending and investing in hopes that it will curb demand and alleviate inflationary pressure.

Expectations of future inflation can influence current interest rates. If investors anticipate higher inflation, they will demand higher interest rates on investments to protect their purchasing power. Consequently, market forces may drive up interest rates in response to those expectations.

Inflation sometimes can trigger a wage-price spiral. As prices rise, workers may demand higher wages to maintain their standard of living. If businesses pass on these increased labor costs to consumers in the form of higher prices, it can create a cycle of rising wages and prices, leading to more inflation. To break this cycle, central banks may raise interest rates to discourage borrowing and spending, thus reducing demand and inflationary pressures.

It's important to note that the relationship between interest rates and inflation can be complex and subject to other economic factors. Central banks often consider a variety of economic indicators and factors before adjusting interest rates to achieve their dual mandate of full employment and price stability while also supporting sustainable economic growth.

Rising interest rates and inflation can have several negative effects on households and the broader economy, including increased borrowing costs, reduced consumer spending, lower business investment and a slower housing market.

Here are some of the top drawbacks of higher interest rates, along with some tips on how you may be able to mitigate them:

Higher interest rates make borrowing more expensive for households, leading to higher monthly payments on mortgages, car loans, credit cards and other forms of credit. This can strain your budget and reduce your disposable income, potentially leading to less consumer spending.

Tip: You can reduce the burden of increased borrowing costs by paying off any high-interest variable debt you have. For example, credit cards typically charge higher rates than other forms of debt, and they tend to raise their rates when the Fed raises its rates.

As borrowing becomes more expensive and debt burdens increase, consumers may cut back on discretionary spending. Reduced consumer spending can have a significant impact on businesses, particularly those in sectors that rely heavily on consumer demand. This can potentially lead to reduced revenues, job losses and economic slowdown.

Tip: While reduced consumer spending may not be a problem for the economy yet, it can be wise to tighten your monthly budget at this time, especially if you're trying to find extra money to pay down debt before rates rise higher.

Higher interest rates also affect businesses' borrowing costs. When the cost of capital rises, businesses may postpone or scale back investment projects. Reduced investment can lead to slower economic growth and hinder job creation.

Tip: Whether or not you're at risk for a layoff, this can be a good time to be sure your emergency fund is loaded up just in case. A general rule is to maintain three to six months of living expenses in an easily accessible savings account.

Higher interest rates can dampen demand in the housing market. Higher mortgage rates increase the cost of homeownership, making it more challenging for potential homebuyers to enter the market. This can lead to a slowdown in housing sales and construction activity.

Tip: If you're thinking of buying a home when rates are high, take a closer look at your local real estate market. Consider the full cost of owning versus the cost of renting. For example, after factoring in your loan payment, which includes principal, interest, taxes and insurance, you'll still have other costs, such as maintenance and improvements. Renting could be a more advantageous financial decision for the short term.

Rising interest rates can make it difficult for households with variable-rate loans to manage their debt. For example, homeowners with credit cards, home equity lines of credit and adjustable-rate mortgages may face higher monthly payments when interest rates rise, potentially leading to defaults and foreclosures.

Tip: For those with existing debts, high interest rates can provide an incentive to pay off loans and credit card balances more quickly. This can lead to reduced interest expenses and stronger personal finances in the long run.

Governments with large amounts of debt can face higher interest payments as rates rise. Higher interest costs can strain government budgets and lead to reduced spending on public services and infrastructure.

Tip: The upside is that high interest rates make fixed-income investments more appealing to investors seeking stable returns. Bonds, Treasury securities and other fixed-income instruments offer higher yields during periods of high interest, making them attractive options for savers and risk-averse investors.

If the negative impacts of rising interest rates outweigh the positive effects, it can lead to overall slower economic growth or even a recession, reduced consumer spending, lower investment and other factors that can further slow economic activity.

Tip: Because the Fed is raising rates to fight inflation, their actions could lead to a recession. That means this could be a good time to review your investments and their diversification.

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While high interest rates can have negative effects on personal finances, they also can bring some positive impacts, such as higher rates on savings and investments, attractive fixed-income investments and incentives to pay off debt.

Here are some potentially positive results of high interest rates:

High interest rates can lead to higher returns on savings accounts, CDs and other fixed-income investments. Savers and investors can earn more interest on their deposits, which can help them build wealth over time and achieve their financial goals faster. High-yield money market accounts and Treasury bonds also can provide more interest income to savers and investors.

High interest rates can discourage individuals from taking on excessive debt. When borrowing becomes more expensive, people may think twice before making large purchases on credit, which can lead to more responsible financial behavior and reduced risk of falling into a debt trap.

High interest rates in a country can attract foreign investors seeking higher returns on their investments. As a result, the country's currency may appreciate relative to other currencies. For individuals who hold foreign investments or plan to travel or study abroad, this can increase the purchasing power of their currency.

In some cases, high interest rates are implemented by central banks to combat excessive inflation or to stabilize the economy. When interest rates are raised to control inflation, it can help maintain price stability and the purchasing power of consumers.

When inflation is running hot and interest rates are rising, the broader economy can begin to look daunting, especially when it begins to affect your personal financial situation. It's natural to be concerned, but it's important not to allow emotion to lead your financial decisions. With a strong plan in place, you'll have the confidence to hold steady through this time.

Reaching out to a financial advisor can help you navigate the uncertainty and volatility by being sure that you're on track to reach your long-term financial goals, no matter what the economy is doing in the short term.