How raising 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.Win McNamee | Getty ImagesThe Federal Reserve looks set to raise its benchmark rate again today, and may even hand out the first three-quarter-point hike in 28 years.The central bank is likely to raise its target federal funds rate again to address the worst inflation in about 40 years.It may move fast and raise interest rates by 75 basis points instead of 50 basis points, as was the previous expectation, because inflation has remained high. A basis point is equal to 0.01%.More from Invest in You:Want to give your finances a spring cleaning? First, get organizedHere’s what to know about managing your debt in retirementWant to find financial success? Here’s how to get startedIn May, inflation rose 8.6%, more than analysts expected and at the fastest clip since 1981. Yet consumers who are already grappling with higher prices putting a strain on their wallets may be wondering how increasing borrowing costs will help tamp down inflation.”This is something really hard for the typical consumer to understand, seeing these fast price raises that are so unfamiliar to large parts of our population who haven’t seen inflation rates like this before,” said Tara Sinclair, a senior fellow at the Indeed Hiring Lab. “And then trying to figure out the Fed’s complicated role in all of this is very confusing.”Here’s what you need to know.The Fed’s main tool to battle inflation is interest ratesThe 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.Its main tool to battle inflation is interest rates. It does that by setting the short-term borrowing rate for commercial banks, and then those banks pass rates along to consumers and businesses, said Yiming Ma, an assistant finance professor at Columbia University Business School.That higher rate influences the interest you pay on everything from credit cards to mortgages to car loans, making borrowing more expensive. On the flip side, it also boosts rates on savings accounts.How raising rates can slow inflationBut 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 McBridechief financial analyst, BankrateThere 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 economyThe 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 betterWhen the Fed does lift rates, it’s also likely that people will see the downsides of those increases before any improvement on inflation, said Sinclair.Basically, that means consumers may have to pay more to borrow money and still see higher prices at the gas pump and grocery store. That scenario is particularly tough on low-income workers, who have seen wages rise but not keep pace with inflation.Of course, ideally, the central bank would like to raise rates gradually so that the economy slows just enough to bring down prices without creating too much additional unemployment. The Fed wants to avoid a recession as well as the chance of stagflation — a situation in which inflation remains high while the economy slows.”They have to carefully walk that tightrope,” said Sinclair.SIGN UP: Money 101 is an 8-week learning course to financial freedom, delivered weekly to your inbox. For the Spanish version Dinero 101, click here.CHECK OUT: The ‘old convention’ for saving in retirement won’t work anymore, expert says: Here’s how to shift your strategy with Acorns+CNBCDisclosure: NBCUniversal and Comcast Ventures are investors in Acorns.

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