Interest rates

Why the Fed is raising interest rates to fight inflation

Hass avocados are displayed in the produce section of a United Market on February 7, 2022 in San Anselmo, California.

Justin Sullivan | Getty Images

The Federal Reserve is expected to raise interest rates this year for the first time since 2018 to deal with the worst inflation in 40 years, boosted by the coronavirus pandemic.

Consumers already impacted by higher prices might wonder how this will help mitigate rising costs.

In January, the consumer price index jumped 7.5% on the year, more than expected by economists and the fastest gain since February 1982. It also marked the fourth consecutive month of price increases. record price.

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“It’s something really hard for the typical consumer to understand, seeing these rapid price increases that are so unfamiliar to a large portion of our population who have never seen inflation rates like this before. “, said Tara Sinclair, senior researcher at Indeed. Recruitment Lab. “And then trying to understand the complicated role of the Fed in all of this is very confusing.”

Here’s what you need to know.

The Fed’s Mandate

The Federal Reserve has a few main goals it focuses on in the economy: promoting maximum employment, maintaining price stability, and having moderate long-term interest rates.

Typically, the central bank aims to keep inflation around 2% a year, a benchmark it was lagging before the pandemic but now needs to address.

The Fed uses interest rates as an accelerator pedal or as a drag on the economy when needed.

Greg McBride

chief financial analyst at Bankrate

The main tool the Fed can use to fight inflation is interest rates. It does this by setting the short-term borrowing rate for commercial banks, and then those banks pass it on to consumers and businesses, said Yiming Ma, an assistant professor of finance at Columbia University Business School.

This rate influences everything from credit card interest to mortgages and auto loans, making borrowing more expensive. On the other hand, it also increases the rates for high-yield savings accounts.

Higher rates and the economy

But how do higher interest rates drive up inflation? By slowing down the economy.

“The Fed uses interest rates as a throttle or brake on the economy when needed,” said Greg McBride, chief financial analyst at Bankrate. “With high inflation, they can raise interest rates and use that to drag the economy down in an effort to get inflation under control.”

Basically, the Fed aims to make borrowing more expensive so that consumers and businesses delay any investment, thereby cooling demand and bringing prices under control.

There could also be a side effect of easing supply chain issues, one of the main reasons for the price spike right now, McBride said. Still, the Fed cannot directly influence or fix supply chain issues, he said.

“As long as the supply chain is a problem, we will likely face external wage gains,” which boost inflation, he said.

What could go wrong

The main concern among economists is that the Fed is raising interest rates too quickly and dampening demand too much, thus slowing the economic recovery.

This could cause the unemployment rate to rise if companies stop hiring or even lay off workers to stay afloat. If the Fed really overshoots the rate hikes, it could even push the economy back into a recession, halting and reversing the progress it has made so far.

Dealing with inflation in the economy is like treating cancer with chemotherapy, Sinclair said.

“You have to kill chunks of the economy to slow things down,” she said. “It’s not a pleasant treatment.”

Of course, it will take some time for any Fed action to have an impact on the economy and curb inflation. That’s why the Federal Open Market Committee carefully monitors economic data to decide how much and how often to raise rates.

Things might get worse before they get better

The Fed has signaled that it will likely raise interest rates in March. The amount of this first hike and what will follow is still unclear.

Markets are anticipating a rate hike of 50 basis points, or 0.5%, in March, but have reached no consensus on further hikes.

St. Louis Fed President James Bullard said Monday he believes the Fed should raise interest rates quickly.

“I think we need to anticipate our planned housing removal more than we would have before,” Bullard told CNBC’s Steve Liesman during a “Squawk Box” interview. “We were surprised by the rise in inflation. That’s a lot of inflation.”

Last week, he said in an interview with Bloomberg News that he believed the Fed should raise rates by up to 1 percentage point by July. Other regional bank executives have expressed a desire to raise rates starting in March, but none are as hawkish as Bullard.

When the Fed does eventually raise interest rates, it’s also likely that people will see the negatives of those increases before any improvement in inflation, Sinclair said.

Basically, this means consumers may have to pay more to borrow money and still see inflated prices at the gas pump and grocery store early on. This is particularly harmful for low-income workers, who have seen their wages rise recently but are not keeping pace with inflation.

Of course, the goal is for the Fed to gradually raise rates so that the economy slows just enough to bring prices down without raising unemployment too much.

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

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