Relationship Between Interest and Inflation Rate

Understanding the relationship between inflation and interest rates is essential in macroeconomic analysis and policy formulation. Interest rate affects borrowing, saving, and investment, while inflation affects purchasing power and economic stability. In economic theory, these two variables are linked by the Fischer effect, which postulates that the change in interest rate is directly proportional to the inflation rate. This paper uses data from the United States from 2014-2024 to explore the relationship between the two variables. It uses a linear regression analysis model to determine if interest rates impacted inflation during this period and provide meaningful insights for economic policy formulation.

Theoretical Relationship Between Inflation and Interest Rates

Economic theory provides several frameworks to understand the relationship between inflation and interest rates. One of the well-known models in this area is the Fisher Effect, which argues that the nominal interest rate equals the expected real interest rate plus expected inflation. If inflation expectations rise, nominal interest rates will rise in the same way as long as the real rate of interest remains stable (Adrian, 2023). Inflation and interest rates may not adjust simultaneously due to sticky prices, delayed policy reactions, or sporadic economic shocks. Furthermore, a central bank operates slowly, and markets can be impacted by expectations about rates rather than the rates observed in the economy.

A real interest rate, once adjusted for inflation, can behave irregularly. Specifically, if nominal interest rates remain static while inflation rises, the real interest rate becomes negative incentivizing borrowing and spending. High borrowing and spending make it more difficult to control inflation. It also creates a troubling situation where central banks rely upon real interest rates to signal a time for stimulating or cooling down the economy depending on inflation expectations and appropriate timing.

Empirical Findings from U.S. Data (2014–2024)

Inflation and real interest rates spiked in the United States between 2012 and 2022. According to the Federal Reserve Bank of Cleveland (2024), the level of inflation fluctuated in a state of low and stable inflation from 2016 to 2020 at about 1-2% before rising sharply in 2021 and 2022, showing a peak of over 8%, for reasons from pandemic limitations of disruption and consumer demand. The real interest rates remained positive until 2020, after which they turned negative momentarily before ticking up through 2024. The correlation between the two observed variables was weakly related and implies that other elements drove inflation in this period of economic volatility.

The regression estimated the inflation rate from the real interest rate using U.S. data for 2014 to 2024. The equation was:

Inflation Rate (π)= 1.96+ 1.05i

The regression shows a positive coefficient for the real interest rate. The result suggests that inflation will increase slightly as interest rates increase. However, this is a weak relationship statistically. The R squared 0.088 means that only 8.8% of the variation in inflation can be accounted for by the variation in the real interest rate. Furthermore, the p-value of 0.375 for the coefficient indicates that the relationship is not statistically significant. A p-value of 0.375 means the correlation between inflation and the real interest rate was more likely due to chance than a reliable economic correlation.

These findings indicate that, while real interest rates may still play a role, this decade witnessed greater driving forces causing inflation. Factors including disruptions in global supply chains, workforce shortages, fiscal stimulus related to a pandemic, and geopolitical conflicts led to increased inflation, especially in 2021 and 2022 (Bai et al., 2024). In those two years, inflation increased while real interest rates were low or negative, inconsistent with economic model expectations. The regression model on which the explanatory power is limited reflects the typical nature of inflation and supports the idea that real interest rates cannot account for all movements in inflation.

Implications for Monetary Policy and Economic Analysis

The inconsequential statistical relationship between inflation and real interest rates has important implications for monetary policy. It indicates that relying only upon interest rate adjustments to control inflation may not solve the inflation problem during external shocks or major disruptors in the marketplace. During 2020-2022 and beyond, inflation increased rapidly due to supply constraints and a stimulus-driven increase in consumer demand, yet real interest rates remained low or negative (Koch, 2023). This shows that higher interest rates may lower inflation, highlighting that traditional monetary tools may not always help control inflation in a rapidly changing and unstable economic context.

Policymakers must consider factors apart from interest rate setting, such as inflation expectations, the state of the global economy, wage growth, and commodity prices. Policy considerations should be anticipatory and flexible to the effects of lag and feedback. Economists and analysts should consider combining situational and behavioral models with real-time data to provide a more complete picture. This assessment demonstrates that inflation cannot be understood through interest rates alone but requires a broad evaluation of other macroeconomic indicators and extrinsic influences affecting price stability.

Conclusion

In conclusion, the data analysis from 2014 to 2024 suggests a weak and statistically insignificant relationship between the real interest rate and inflation in the United States. Economic theory predicts direct linear relationship but the real-world experience from the period demonstrates other intervening forces, such as supply shocks, fiscal policy, and global events, had a larger influence on inflation rate. The regression model's low R-squared and high p-value validate that the real interest rate alone does not sufficiently explain inflation.