A small, steady amount of inflation is a sign of a healthy economy. But when prices rise too much too quickly, it lessens purchasing power, straining consumers and businesses.
Fortunately, the Federal Reserve (aka, “the Fed”) has a tool in its back pocket that can help tamp down inflation — the federal funds rate. By raising this benchmark rate, the government influences other interest rates, including rates for consumer and business loans. This makes borrowing more expensive and can help cool the economy, bringing inflation under control.
That said, raising interest rates doesn’t lower the pace of price increases overnight. There are also some risks involved in raising the federal funds rate too aggressively. Here’s a closer look at how interest rates and inflation interact.
Key Points
• To help control inflation, the Federal Reserve may raise the federal fund rate, which typically raises the interest rates offered by financial institutions.
• Raising interest rates makes borrowing more expensive, which tends to reduce consumer and business spending.
• Higher interest rates also encourage saving, since consumers will typically see higher interest rates on their savings accounts.
• It can take time for the Fed’s interest rate hikes to effectively ease the price of goods and services, and there are other factors that can affect pricing.
• Potential downsides to rising interest rates may include an economic slowdown, increased unemployment, and an increase in the cost of financing government debt.
The Relationship Between Interest Rates and Inflation
Inflation is generally defined as a sustained increase in the price of goods and services consumers regularly buy. While the inflation rate can be measured in a number of different ways, the Fed typically uses the Personal Consumption Expenditures Index (PCE) as its main measure of inflation. The PCE tracks changes in consumer spending on a wide range of goods and services.
The Fed has a stated goal of keeping inflation around 2% each year, as measured by the annual increase of the PCE index. To control inflation, the Fed will often take steps to influence interest rates. When interest rates are high, it costs more for consumers to use credit cards and take out mortgages and car loans. As a result, they typically start spending less. When demand for goods and services falls, it puts pressure on businesses to lower prices. Higher interest rates also help reduce spending by encouraging saving, as consumers benefit from higher yields on savings accounts.
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Mechanisms of Interest Rate Increases
In the U.S., decisions on monetary policy are made by the Federal Open Market Committee (FOMC), which is made up of the Board of Governors of the Federal Reserve as well as five of the presidents of the 12 Federal Reserve banks. Congress has mandated the Fed to set monetary policy so as to promote maximum employment and stable inflation (generally around 2% annually).
The members of the FOMC meet regularly to discuss monetary policy, viewing various economic indicators such as the employment rate, inflation rate, and current interest rates. Based on these market factors, they set the country’s target interest rate, known as the federal funds interest rate (also known as the federal funds target rate).
The federal funds rate acts as a reference for the interest rates big commercial banks charge each other for the overnight loans. A change in the rate that banks charge each other for loans impacts other market rates (like the prime rate) and, consequently, interest rates offered by banks and other financial institutions to consumers and businesses.
Effects of Higher Interest Rates on the Economy
When the Fed raises interest rates, it can have a number of effects on the economy, including:
• Reduced household spending. When interest rates on credit cards go up, consumers generally spend less on their cards. In order to afford credit card payments that now may be higher, they might also cut overall spending on goods and services.
• Slowdown in home sales. Higher rates on mortgages make it more expensive to buy a home. As a result, many consumers may decide to continue renting and hold off on purchasing a home.
• Sluggish business growth. When the cost of financing goes up, businesses may decide to hold off making large purchases or other investments in expansion and growth.
• Increased saving. Higher interest rates on savings accounts, especially high-yield savings accounts, incentivize saving, since account holders will earn a higher return on their balances.
• More foreign investment. Higher interest rates can attract foreign investors looking for better returns on their investments, which can increase demand for U.S. currency.
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How Higher Rates Combat Inflation
When the federal funds rate rises, it sets off a ripple of effects in the U.S. economy. It makes it more expensive for commercial banks to borrow from each other, more expensive for businesses to finance large projects, and more expensive for consumers to get mortgages and other types of loans. This ultimately leads to less borrowing, less spending, more saving (thanks to good interest rates on bank accounts), and less overall money in circulation. Altogether, this tends to have a cooling effect on the economy, which helps to lower inflation.
It’s important to keep in mind, however, that the impacts of monetary policy set by the Fed are generally not swift. It can take upwards of 12 months for a rate hike to wend its way through the economy and actually ease prices. It’s also important to keep in mind that there are many things that impact inflation — from supply chains to labor costs to consumer demand. Interest rates are only one influencing factor.
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Potential Drawbacks of Raising Interest Rates
While raising interest rates can be an effective tool for fighting inflation, it is not without its drawbacks. Here’s a look at some of the potential downsides of raising interest rates.
• Economic slowdown: As borrowing becomes more expensive, businesses may delay expansion or cut back on hiring, leading to slower job creation. Consumer spending may also decline, resulting in reduced demand for goods and services. Over time, this can lead to a slowdown in gross domestic product (GDP) growth, potentially tipping the economy into recession.
• A rise in unemployment: As businesses face higher borrowing costs, they may reduce their workforce or halt new hiring to cut expenses. Industries that rely heavily on borrowing, such as construction and real estate, can potentially see significant job losses as investment slows.
• Rise in the government debt costs: When interest rates rise, the cost of servicing the U.S. government’s debt also increases. Higher interest costs can strain the government’s budget and reduce the funds available for other important programs, such as healthcare, education, and infrastructure.
The Takeaway
Raising interest rates is a powerful tool used by the Federal Reserve, the central bank of the U.S., to control inflation, particularly in an overheating economy. By making borrowing more expensive and encouraging saving, higher interest rates reduce consumer spending and business investments, which can help cool demand and bring inflation under control.
However, this approach is not without its downsides, as it can lead to slower economic growth, increased unemployment, and higher government debt costs.
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FAQ
How quickly do interest rate hikes affect inflation?
The effects of interest rate hikes on inflation can take at least 12 months to materialize. Central banks raise rates to reduce borrowing and spending, which in turn lowers demand for goods and services, along with prices. However, it takes time for this chain of events to ripple through the economy. On top of that, inflation is influenced by numerous other factors (including global supply chains, energy prices, and labor markets), which can also delay the impact of rate hikes.
Can raising interest rates cause a recession?
Yes, raising interest rates too aggressively can potentially cause a recession. Higher interest rates increase the cost of borrowing for consumers and businesses, which can reduce spending and investment. If rates rise too quickly or remain elevated for too long, the economy may slow significantly, leading to reduced consumer demand, lower business activity, and ultimately job losses. If economic output contracts for two consecutive quarters, it generally indicates a recession.
What happens to savings accounts when interest rates rise?
When interest rates rise, savings account holders typically benefit from higher returns. In response to rising benchmark rates set by the Federal Reserve, many (though not all) banks and credit unions will increase the interest rates they offer on savings accounts This can make saving more attractive than spending.
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