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How does raising interest rates lower inflation?

by Ana Lopez
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Between March 2022 and March 2023, the Fed raised the target rate of the federal funds by 475 basis points, or 4.75%. This news received a lot of attention in the media because it was not immediately clear whether the continued interest rate hikes would curb inflation.

If you read this article, there is a chance that inflation is now high, and you’ve heard that the Fed is raising rates. Many people are confused about the Fed’s monetary policy and how rate hikes might affect what you pay at the gas pump or grocery store. In this article, we try to clarify the relationship between the two.

Key learning points

  • When consumer demand exceeds supply, the prices of goods and services rise until the Fed can restore equilibrium.
  • Higher interest rates tend to discourage spending and encourage saving, which lowers demand to rebalance supply and demand.
  • The biggest risk in raising interest rates to lower inflation is that there is usually no soft landing, which could push the economy into recession.

What you probably heard

If you’ve seen a news clip about the Fed raising rates or heard a family member complain about the high cost of borrowing, you may have preconceptions about what raising rates means.

For example, you might think that interest rate hikes always cause an economic recession. You may also have heard that the Fed wants to raise unemployment to stop inflation. Neither gives a completely accurate picture of the situation.

The Fed generally raises interest rates when inflation does not resolve itself. Although an economic recession is a risk of interest rate hikes, it is not a certainty. Let’s take a closer look at the Fed’s thought process and how its actions affect inflation.

monetary policy

The Federal Reserve is the central banking system of the US and has the dual mandate of sustaining sustainable growth and maximizing employment. The Fed influences these things through monetary policy, the tools at the Fed’s disposal to control the country’s money supply.

The target rate of the federal funds is one of the monetary policy tools of the Fed.

The Fed Funds rate indirectly affects the rate at which banks borrow and lend their excess reserves to each other overnight. Because banks must meet specific reserve requirements related to the amount of money they have on hand, a higher Fed Funds rate discourages borrowing.

The Fed Funds rate doesn’t just affect banks. Borrowing becomes more expensive for consumers when the Fed raises interest rates, encourages people to save money, and demand falls. When demand falls, prices can stabilize and inflation is curbed.

But before we get into the details, we need to understand what causes high inflation.

What Causes High Inflation?

There are many possible reasons why In an economy, inflation can rise. In general, inflation can increase when the cost of raw materials or production rises, demand for products exceeds supply, or when government fiscal policies create distortions. Many other factors could exacerbate inflation, from supply chain issues caused by global conflicts to unexpected levels of demand as we saw governments lift pandemic restrictions.

For a case study of rising inflation and the Fed’s response, let’s look at the run-up to the 475 basis point rate hike from 2022 to 2023.

Initially, spring 2021 inflation was labeled “transient” as the Fed believed the unique spike in global demand brought about by the easing of pandemic restrictions caused the price hike. Supply chains couldn’t keep up as they had become accustomed to a ‘new normal’, so as consumer demand shifted, there was a slowdown as supply chains caught up.

There were also unique global events impacting inflation in 2022. The Russian attack on Ukraine disrupted global supply chains and many countries introduced sanctions against Russia. Russia’s war with Ukraine had a major impact on energy prices, as the former had a large market share of European gas.

This huge mismatch in supply and demand led to higher prices, with inflation reaching 8.3% year-on-year in August 2022.

How does raising inflation lower inflation?

It may seem counterintuitive to hear that central banks are raising interest rates because everything is getting more expensive. But we cannot stress enough that price stability is the goal of raising rates.

With high inflation (unsustainable economic growth), the central bank has to reduce the money supply to restore the balance between supply and demand. In other words, demand must slow down enough to catch up with supply.

When borrowing money costs more due to higher rates, consumers are less likely to have credit card debt or apply for a loan. A car loan or mortgage is now more expensive. You may not buy that house if borrowing costs you more than it did a year ago. Consumers may think twice before putting a transaction on a high-interest credit card.

The Fed aims to reduce demand enough to match supply, which should contain rising prices. The challenge is to get the whole economy to an acceptable level without going into recession.

Does raising interest rates always work to fight inflation?

The obvious question many of us have is whether monetary policy always works. It feels frustrating that the step to fight inflation is to cool down the entire economy. A common effect of rising interest rates is higher unemployment, as many businesses adjust to lower revenues and a halt in growth.

The truth is that the Fed only has so many tools it can use to control inflation. The Fed can raise interest rates to fight inflation, but it cannot enact fiscal policies or pass laws.

The government introduces fiscal policies and legislation to support central banks. Using our 2022-23 case study again, we saw that fiscal policy was used in August 2022 when President Biden Inflation Reduction Act in the law. The government can also make deals with other countries to increase supply, alleviating raw material supply issues.

The Fed is obviously also limited when it comes to influencing global supply chains. Based on our case study, the Fed could not single-handedly solve the conflict in Ukraine, which caused massive disruptions to the world’s grain, gas and oil supply.

The danger that the Fed will not manage inflation is serious. Stagflation, while rare, is a possibility. Stagflation refers to a uniquely dangerous economic situation where inflation and unemployment are high and economic demand is stagnant.

While the Fed will try to match demand with supply, supply chain issues make this recovery difficult. There are no ready-made solutions for supply management as the central bank cannot control the global conflict.

What are the consequences of rising interest rates?

Many consequences come with raising interest rates; some people can suffer more than others.

When borrowing money becomes more expensive, getting a mortgage, applying for a car loan, or getting a business loan to grow a business becomes more expensive. Businesses and consumers will spend less, causing the economy to cool. Unfortunately, this can also lead to job loss. Any industry affected by the rate hikes is likely to report lower earnings, leading to layoffs and higher unemployment rates.

It is difficult to anticipate the impact of any rate hike on consumer spending. The Fed is aiming for a soft landing where prices cool without massive job losses and an outright recession.

How can you invest your money?

When the Fed announces rate hikes, the stock market tends to suffer. It’s going to be a challenge find the best investment when interest rates are high, as uncertainty can lead to a sell-off in the stock market.

Companies generally considered to be recession-resistant include utilities, food and beverage retailers, discount stores, and healthcare companies. When high interest rates lead to a recession, discretionary spending tends to decline, but not in the essential sectors of the economy.

Bond prices and interest rates

When the Fed adjusts the Fed Funds rate, it affects the bond market. Bonds and interest rates have an inverse relationship. Because most bonds have a fixed interest rate when interest rates fall, bonds with now relatively high yields become more attractive to bond investors. This pushes the price of bonds higher. Conversely, if the Fed raises interest rates, bonds with relatively low yields become a less attractive investment. causing their prices to fall.

You may hear about something called an inverted yield curve. This refers to shorter-term bonds that have higher yields than longer-term bonds. This is considered a reversal of what should be true: taking a bond with a longer maturity (one with a higher risk) should give you a higher return.

An inverted yield curve suggests that investors lack confidence in the future of the economy, and experts see it as an indicator of an impending recession.

It comes down to

News about high inflation is often doom and gloom. Rate hikes can end corporate growth periods, lead to unemployment and push the economy into recession. At the same time, out-of-control inflation can lead to even more dangerous economic situations.

The Fed will fight inflation by raising interest rates until supply and demand are balanced again. Don’t be surprised at interest rate hikes in the future, as this is a common response to high inflation. You can financially prepare for the worst-case scenario by saving money and diversifying your income.

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