WTFinance is happening with inflation and what does it mean for your budget?

Inflation is a complex topic, but it boils down to one idea most of us already know: things cost a lot more today than they did just a couple of years ago. At the same time, wages aren't a lot higher than they were a couple of years ago. 

Let’s talk about inflation, how it’s managed by the Federal Reserve, and how it impacts your budget—and your wallet.

What is the Fed interest rate?

The Federal Reserve is the central banking system of the U.S. It’s where money policy is created to promote economic growth. 

When the talking heads on TV mention the Fed interest rate, they’re referring to what’s called the Fed Funds rate. This is a baseline rate that banks can use when they lend money to each other. It’s sometimes called a benchmark. 

In the last year, the Federal Reserve has increased interest rates several times (aka “rate hikes”)—and it might do so again in 2023. This matters because the cost to banks is usually passed on to consumers, to you, in different ways.

The Fed interest rate and inflation

A Fed rate hike is usually made in response to inflation. It’s an attempt to slow inflation—to keep prices from skyrocketing. 

Here are two main ways the Fed deals with money policy through its benchmark interest rate.

• The Fed wants to encourage money to move through the system when inflation is low. That means that when the benchmark rate is low, borrowing money is cheaper and spending is higher. Banks, businesses, and consumers are all willing to take on more debt—and spend more—when borrowing is cheap. When money moves through the system, we feel more comfortable making purchases like TVs and cars. We’re more willing to eat out. These activities also support jobs, so more people have money to spend.

• But when inflation is on the rise, usually above 2%, the Fed hopes to slow it down. So they meet and decide on a rate hike. This makes borrowing more expensive. When fewer people borrow to make purchases, demand drops. Hopefully, the result is that prices either drop or at least stop rising. 

What happens to your wallet is the result of these moves.

How a Fed rate hike hits your wallet

Inflation is all about the prices you pay for goods and services. We’ve all experienced inflation at the grocery store. Remember when eggs suddenly spiked in price?

The Fed’s response to inflation, a rate hike, hits you in the wallet because debt becomes more expensive. If you have any type of debt, or if you need to get a loan, it’ll cost you more because of the Fed rate hike. You’ll likely find that lenders are charging higher rates on:

• Credit cards

• Personal loans

• Car loans

• Home equity lines of credit

These are tools many of us use to manage our finances. Unfortunately, a rate hike means these approaches are more expensive. The vast majority of credit cards have a variable interest rate. That means when the Fed raises rates, your card issuer will raise your rate. If you’re carrying a credit card balance, you’ll start paying even more in interest each month—and that can add up quickly. 

The silver lining of a Fed rate hike

While debt becomes more expensive and can cause additional stress on top of price hikes due to inflation, there's a small silver lining.

The money you can earn on deposits and savings increases when the Fed interest rate goes higher. Many savings accounts start paying more, especially high-yield savings accounts. The interest on savings is never as high as the interest on credit cards, but higher earnings can offset the cost of your debt if you find the right account to park your money. High-yield savings accounts at online banks tend to offer the best rates. 

As you battle inflation, compare prices at different stores to reduce your costs, consider cutting back on unneeded spending, and look for ways to pay down debt faster.