Lost in the flurry of headlines regarding the conflict between the White House and the Federal Reserve is the wildcard for lowering interest rates more broadly – inflation expectations.
What Is Inflation—And Why Does It Matter?
Inflation is a persistent increase in consumer prices—or, put another way, a decrease in the purchasing power of money. For lenders, this matters deeply. At a minimum, they want to maintain the value of the money they lend. If they expect inflation to rise, they’ll demand higher interest rates to compensate. More on inflation can be found in Part 6 of my Money and Banking Series.
Stated interest rates – the rates quoted by lenders – are called nominal interest rates. Nominal rates are unadjusted for expected inflation. In contrast, real interest rates, are interest rates adjusted for inflation. We can think of a nominal interest rate as the sum of the real interest rate and the expected inflation rate.
Nominal interest rate = Real interest rate + Expected inflation rate
Conversely, we can think of the real interest rate as the nominal interest rate minus the expected inflation rate.
Real interest rate = Nominal interest rate – Expected inflation rate
The Fed’s Dual Mandate and Inflation Target
The Federal Reserve operates under a congressional mandate to:
- Maintain price stability
- Promote full employment
Monetary policy – policy actions that expand or contract the supply of credit – is conducted in accordance with these goals. Importantly, price stability doesn’t mean zero inflation. Instead, the Fed targets an inflation rate of 2% annually, a level that allows for flexibility in adjusting rates during economic downturns. For a deeper understanding of monetary policy check out Part 5 of my Money and Banking series.
In 2012, the Federal Reserve announced an explicit inflation target of 2% annually. During much of the post-crisis period, however, actual inflation ran less than 2%. As a result, we experienced a prolonged period of historically low interest rates.
What Changed? The Pandemic, Stimulus, and Policy Lag
Then came 2020. The COVID-19 pandemic disrupted global supply chains and brought economic activity to a halt. In response, the Fed slashed the federal funds rate to near zero and unleashed a wave of monetary expansion. Meanwhile, the 2021 fiscal stimulus added fuel to the fire—at a time when supply constraints hadn’t yet eased.
The result? Inflation surged to its highest level since the 1980s.
Initially, Fed officials labeled rising prices as “transitory.” But when inflation proved persistent, the Fed was forced to reverse course—raising interest rates aggressively through 2022 and into 2023. That’s the rate environment we remain in today.
How the Fed Actually Influences Interest Rates
The Fed doesn’t directly set mortgage rates or business loan rates. It influences them indirectly by targeting the federal funds rate—the rate banks charge each other for overnight loans.
Here’s how it works:
- The Fed sets the Interest Rate on Reserve Balances (IORB)—what it pays banks for holding funds.
- An increase in the IORB leads to an increase in the federal funds rate.
- A decrease in the IORB leads to a decrease in the federal funds rate.
- This, in turn, affects broader credit conditions, from Treasury yields to consumer loan rates.
Why the 10-Year Treasury Matters to You
While the federal funds rate influences short-term rates, long-term rates—like those on 10-year Treasury Notes—play a larger role in business investment, home mortgages, and retirement portfolios.
For investors and business owners, the 10-year Treasury is a critical benchmark. It reflects long-term inflation expectations, investor confidence in Fed policy, and the economy’s outlook.
The Role of Credibility in Controlling Inflation Expectations
Controlling inflation is not just about interest rates. It’s also about trust. Bond markets must believe the Fed is independent, credible, and committed to price stability. That trust was hard-won—particularly after the inflation crisis of the 1970s, which required aggressive action by Fed Chair Paul Volcker to reverse.
Undermining that credibility—by allowing political interference in rate decisions—can lead to:
- Higher inflation expectations
- Higher long-term interest rates
- Greater volatility in financial markets
Key Takeaways for Investors
- Interest rates reflect both real return and inflation expectations.
- The Fed influences rates indirectly, but credibility is everything.
- Inflation expectations are central to understanding where rates are headed—and how markets will react.
If you’re a long-term investor, business owner, or financially curious learner, watching inflation expectations may give you more insight than the latest political headline.
