How raising interest rates slows inflation

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

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The Fed’s main tool to battle inflation is interest rates

The Federal Reserve has a few main goals with respect to the economy: to promote maximum employment, keep prices stable and ensure moderate long-term interest rates.

Generally, the central bank aims to keep inflation around 2% annually, a number that lagged before the pandemic.

How raising rates can slow inflation

But how do higher interest rates reel in inflation? They help by slowing down the economy, according to the experts.

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

Basically, the Fed policymakers aim to make borrowing more expensive so that consumers and businesses hold off on making any investments, thereby cooling off demand and hopefully holding down prices.

The Fed uses interest rates as either a gas pedal or a brake on the economy when needed.

Greg McBride

chief financial analyst, Bankrate

There could also be a secondary effect of alleviating supply chain issues, one of the main reasons that prices are spiking right now, said McBride. Still, the central bank can’t directly influence or solve that particular problem, he said.

“As long as the supply chain is an issue, we’re likely to be contending with” outsize wage gains, which drive inflation, he said.

The Fed wants to avoid stalling the economy

The main worry for economists is that the Fed raises interest rates too quickly and dampens demand too much, stalling the economy.

This could lead to higher unemployment if businesses stop hiring or even lay off workers. If policymakers really overshoot on rate hikes, 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,” she said. “It’s not a pleasant treatment.”

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 carefully watches economic data to decide how much and how frequently to raise rates.

There is also some uncertainty due to the war in Ukraine, which has also increased prices on commodities such as gas. The Fed will have to watch how the war is hampering the U.S. economy and act accordingly.

It might get worse before it gets better

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