Inflation Threatens to Press Interest Rates Higher

For the past couple of months, the narrative describing the outlook for interest rates has centered around economic growth and the Federal Reserve's reaction to that growth. Now inflation has added a new and potentially ugly twist to that narrative.

Anticipated growth drives a turn in interest rates

Since the end of April, some interest rates have been rising on signs of economic growth. Most notably, job creation has picked up steam -- the first half of 2013 was the best calendar half for job growth since 2005.

Accelerating growth generally can make interest rates rise, and this is especially true now because the Federal Reserve has held interest rates down to stimulate growth. As that growth finally comes through, it is anticipated that the Fed will start to ease its stimulus. While Fed Chairman Ben Bernanke has recently sought to soothe nervous investors by reassuring them that the Fed won't ease short-term rates until growth is more firmly established, longer-term rates will rise naturally as the Fed eases its asset buying programs.

Inflation may force Bernanke's hand

The new twist came Tuesday when the Bureau of Labor Statistics reported that inflation rose by 0.5% in June. That may not sound like much, but it translates to an annual rate of more than 6%.

If markets were nervous about rising interest rates before, they may be even more jittery following this inflation report. Inflation not only drives interest rates higher on its own, but it could also force the Fed to be more aggressive about raising interest rates in order to prevent price increases from getting out of hand.

So far, this flare-up of inflation is just a single-month event, and short-lived inflation blips are not uncommon. However, energy costs were the driving force behind June's higher inflation number, and there hasn't yet been any sign of oil prices easing.

Consumers get bitten on both sides

As it stands now, consumers are getting bitten on both sides -- as savers and as borrowers.

As savers, consumers are stuck with rates on savings accounts, money market accounts and CDs that are near zero. Even with moderate inflation, savings accounts were losing purchasing power, and those losses will accelerate if inflation picks up faster than bank rates rise. So far, that race is simply no contest.

On the borrowing side, consumers are already facing higher mortgage rates. Banks have been quick to raise mortgage rates so they don't get caught short as interest rates rise, and they will be even more aggressive about raising those rates if there is a whiff of inflation in the air.

Looking forward, if interest rates are pushed higher by continued improvement in the economy, that will mean they are being driven by demand, and there are certainly some benefits to that for consumers. However, if rates are pushed higher by inflation, that means they are being driven by fear, and that's not a good situation for consumers.

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