Why the Federal Reserve raises interest rates to combat inflation

On Wednesday, the Federal Reserve will announce its first increase in interest rates since 2018.

In order to combat the most severe inflation since more than 40 year, partly caused by the coronavirus panademic, the central banks is expected to increase its target federal funds rates by 25 basis point. The basis point corresponds to 0.01 percent.

Consumers who already feel the pinch of higher prices on their pockets may wonder if increasing borrowing costs can help to reduce inflation.

The consumer price index soared to a 7.9% annual rate in February,This is the highest point since 1982, when it was first recorded. Rising prices of goods such as foodThe increase in fuel prices drove it and further reduced any wage gains workers might have witnessed over the past year.

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Tara Sinclair from the Indeed Hiring Lab, said that “this is something really difficult for the average consumer to understand” and added, “Seeing these rapid price rises that are so familiar to large portions of our population who’ve never seen inflation rates such as this before,” Tara Sinclair. Then, it is difficult to see the Fed’s role in all this.

These are the facts.

Fed mandate

The Federal Reserve is focused on a few key goals in relation to the economy. They aim to increase employment and stabilize prices while maintaining moderate long-term rates of interest.

In general, the central banks aims to hold inflation below 2% each year. This is an improvement on the number before the pandemic.

Interest rates are the main weapon it uses to combat inflation. Yiming Ma is an assistant professor of finance at Columbia University Business School.

That higher rate influences It increases the cost of borrowing by increasing interest rates, whether you borrow on credit cards or mortgages. It also increases rates in savings accounts.

Economy and Interest Rates

How can higher interest rates reduce inflation? Experts say they help slow down the economy.

Greg McBride chief financial analyst at Bankrate stated that the Fed can use interest rates to either pedal or brake the economy as needed. They can also raise interest rates in order to increase inflation to help control it.  

The Fed’s goal is to raise the price of borrowing in order for consumers and businesses not to borrow. In this way, they hope that prices will fall and cooling demand can be achieved.

McBride said that there could be secondary effects of addressing supply chain problems, which is one reason why prices are so high right now. McBride said the central back is unable to directly impact or solve that problem.

“As soon as there is a supply chain problem, it’s likely that we will be dealing with wage gains from outside,” he stated. This drives inflation.

What the Fed is trying to stop

Economists are most concerned about the Fed raising interest rates too fast and reducing demand too rapidly, which can lead to economic stagnation.

If businesses cease hiring workers or layoff employees, this could result in higher unemployment. Over-regulating rate increases could cause the economy to go into recession. This would reverse the economic progress made.

Sinclair, of Indeed Hiring Lab said that treating inflation in an economy is similar to treating cancer using chemotherapy.

She said, “You must kill certain parts of the economy in order to slow down things.” It’s not pleasant.

You can, of course. it will take some time for any actionTo affect the economy and reduce inflation. The Federal Open Market Committee closely monitors economic data in order to determine how often and how high rates should be raised.

Uncertainty also exists due to the conflict in Ukraine which has increased commodity prices such as gasoline. The Fed must monitor how war has impacted the U.S. economy, and then take appropriate action.

It might get worse before it gets better

Sinclair said that it is possible for people to see the side effects of Fed rate increases, even if they are positive about inflation.

In simple terms, this means that while consumers might have to spend more money to borrow it, they will still pay higher prices for gas and groceries. Low-income workers are particularly affected by this scenario, as their incomes have risen but not kept up with inflation.

The central bank should aim to gradually raise interest rates so that prices fall enough for the economy to not create too many jobs.

Sinclair stated, “They must carefully walk that tightrope.”

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