With prices surging, consumers are feeling pain at the pump and the grocery store. Many consumers know that the Federal Reserve often increases interest rates to combat high prices, but few people understand how interest rates affect inflation.
When the Federal Reserve increases interest rates, this makes it more expensive for companies to borrow money. As a result, the economy slows down, prices drop, and inflation decreases.
Interest rates can affect inflation in a beneficial way, but increased rates also lead to the risk of a recession. That’s why it’s important for consumers to fully understand the relationship between rate increases, inflation, and the overall economy.
High Interest Rates Slow the Economy
When people talk about higher interest rates, they’re usually referring to the Federal Funds Rate. This rate is set by the Federal Reserve, which is the government agency responsible for controlling the supply of money.
The Federal Reserve doesn’t lend money directly to consumers. Instead, it lends money to banks, which then make loans to businesses and individuals.
The Federal Funds rate is the interest rate that banks pay the Federal Reserve in order to borrow money overnight.
If the Federal Funds rate goes up, banks have to pay more to borrow money from the Federal Reserve. Their costs increase, and they pass those increased costs on to consumers and businesses.
These increases can take several forms.
- Higher interest rates for mortgages
- More fees and expenses on credit cards
- Increased borrowing rates for business loans
- More expensive car loans
When consumers and businesses need to pay more to borrow money, they tend to borrow and spend less.
If you have to pay 20% more interest on your credit card balance, for example, you might skip a vacation or cut back on eating out in order to reduce your balance.
Sometimes, banks also tighten their lending standards when the Federal Funds rate goes up. They might stop lending to consumers or businesses with low credit scores, for example.
They might also stop offering new mortgage loans, or they might require higher down payments from borrowers.
When it’s harder to borrow money, businesses often choose to put off big investments, like a new store location or new equipment.
Consumers wait to buy a house or hold off on making big purchases. Across the economy, all that cutting back leads to slower economic growth.
Here is a video that explains how interest rate increases affect inflation.
Slow Growth Decreases Inflation
When businesses see the economy slowing, they know that demand for their products and services will decrease. To keep demand strong, they often lower their prices, stop hiring, or make other cuts to their spending.
Inflation is generally caused by prices that increase too quickly. When businesses decrease their prices to respond to a slowing economy, this causes inflation to drop.
Hiring freezes and job cuts also leave consumers with less cash to spend. This further slows economic growth, forcing businesses to drop their prices even more. Again, those lower prices slow inflation down or even cause it to reverse.
It’s a complex process, but ultimately all these forces mean that the Federal Reserve can use interest rates to affect inflation.
- By increasing the Federal Funds interest rate, the agency makes borrowing more expensive for banks
- Banks pass these costs on to consumers and businesses
- Those higher borrowing costs cause the economy to slow down
- That economic slowing forces businesses to cut down on hiring and to lower their prices
- As prices decrease, inflation decreases as well
Increased Interest Rates Risk a Recession
Although increased interest rates can affect inflation in a useful way, increased rates can also lead to major risks. Again, when interest rates increase, the economy tends to slow down.
This can be a good thing since slowing leads to lower prices and less inflation. But a slowing economy can also lead to less investment, more unemployment, lower wages, and other issues.
If a company has to pay more to borrow money, for example, it might choose to take several actions to cut its costs.
- Laying people off
- Freezing new hires
- Decreasing salaries for existing employees
- Skipping bonuses
These layoffs and other moves can increase unemployment or make it harder for qualified workers to find jobs. They can also cause existing employees to earn less.
Companies might also choose to delay investing in new equipment. A bakery, for example, might put off replacing their ovens with newer models if they can’t get a bank loan to fund the replacement.
Slowing investment can make it harder for businesses to grow in the future.
That’s why increasing interest rates fights inflation, but can also lead to economic challenges. People can lose their jobs, businesses can stop investing in their futures, and wages can decrease.
If interest rates increase too quickly, the economy can even slow so much that it enters a recession.
Interest Rate Increases Are a Balancing Act
Increasing interest rates is vital to controlling inflation, but it’s a delicate balancing act. If the Federal Reserve increases interest rates too slowly, inflation can take off. Prices surge, and consumers see their hard-earned savings whittled away.
If the Federal Reserve increases interest rates too quickly, though, this can slow the economy too much. Inflation will decrease, but so will employment and wages.
If the Federal Reserve overshoots its goals by raising interest rates too fast or too high, the economic impacts can be even worse than inflation.
To get the balance right, the Federal Reserve tends to take several steps.
- Increasing interest rates a little bit at a time instead of all at once
- Announcing their plans well in advance of making any changes to interest rates.
- Guiding investors so they can anticipate how rates will change in the future and start planning ahead
The ultimate goal is to use higher interest rates to lower inflation, but without sending the economy into a recession.
Conclusion
If the Federal Reserve gets the timing right, interest rate increases can affect inflation in a positive and controlled way, bringing down prices without hurting the overall economy.
