How rising interest rates slow down inflation

Federal Reserve Chairman Jerome Powell speaks at a news conference following a meeting of the Federal Open Market Committee May 4, 2022 in Washington, DC.

Win McNamee | fake images

The Fed’s main tool for fighting inflation is interest rates

The Federal Reserve has a few main goals regarding the economy: promoting maximum employment, keeping prices stable, and ensuring moderate long-term interest rates.

In general, the central bank aims to keep inflation around 2% a year, a figure that was lagging before the pandemic.

Their main tool for fighting inflation is interest rates. It does this by setting the short-term loan rate for commercial banks, and then those banks pass the rates on to consumers and businesses, said Yiming Ma, assistant professor of finance at Columbia University Business School.

That higher rate influences the interest you pay on everything from credit cards to mortgages to car loans, making loans more expensive. On the other hand, it also increases the rates on savings accounts.

How Raising Rates Can Curb Inflation

But how do higher interest rates affect inflation? They help slow down the economy, according to experts.

“The Fed uses interest rates to accelerate or brake the economy when necessary,” said Greg McBride, chief financial analyst at Bankrate. “With high inflation, they can raise interest rates and use that to slow down the economy in an effort to control inflation.”

Basically, Fed policymakers aim to make borrowing more expensive so that consumers and businesses refrain from making any investments, which cools demand and hopefully keeps prices low.

The Federal Reserve uses interest rates to accelerate or brake the economy when necessary.

Greg McBride

Chief Financial Analyst, Bankrate

There could also be a side effect of easing supply chain issues, one of the main reasons prices are soaring right now, McBride said. Still, the central bank cannot directly influence or solve that particular problem, she said.

“As long as the supply chain is an issue, we are likely dealing with” outsized wage increases, which drive inflation, he said.

The Fed wants to avoid stalling the economy

Economists’ main concern is that the Fed will raise interest rates too quickly and curb demand too much, crippling the economy.

This could lead to higher unemployment if companies stop hiring or even lay off workers. If policymakers really go overboard on rate increases, it could push the economy into a recession, halting and reversing the progress it has made so far.

Treating inflation in the economy is like treating cancer with chemotherapy, said Sinclair of the Indeed Hiring Lab.

“You have to kill parts of the economy to slow things down,” he said. “It’s not a nice deal.”

Of course, it will take some time for any action to affect the economy and curb inflation. That’s why the Federal Open Market Committee looks carefully at economic data to decide how much and how often to raise rates.

There is also some uncertainty due to the war in Ukraine, which has also increased the prices of raw materials such as gas. The Fed will have to look at how the war is hampering the US economy and act accordingly.

It could get worse before it gets better

When the Fed raises rates, people are also likely to see the downside of those hikes ahead of any improvement in inflation, Sinclair said.

Basically, that means consumers may have to pay more to borrow money and still see higher prices at the gas station and the grocery store. That scenario is particularly difficult for low-income workers, who have seen wages rise but have not kept pace with inflation.

Ideally, of course, the central bank would like to raise rates gradually so that the economy slows enough to lower prices without creating too much additional unemployment. The Fed wants to avoid a recession, as well as the possibility of stagflation, a situation in which inflation remains high while the economy slows.

“They have to walk a tightrope carefully,” Sinclair said.

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