How High Interest Rates curbs Inflation

The Federal Reserve's main goal is to keep inflation under control while preventing a recession. It accomplishes this through monetary policy. The Fed must use contractionary monetary policy to impede economic growth in order to curb inflation.

The appropriate inflation rate, according to the Fed, is around 2%; if it’s higher, demand will push up prices.

By tightening the money supply, the Fed can slow this growth. This is the total quantity of credit that can be issued in the market. The Fed’s activities limit financial sector liquidity, making it more expensive to get loans. It causes a slowdown in economic growth and demand, putting downward pressure on pricing.

The Federal Reserve is expected to raise interest rates this year for the first time since 2018 in response to the coronavirus outbreak, which has sparked the greatest inflation in 40 years.

With the unemployment level approaching a four-decade low, inflation at its highest level in four decades, and global commodity prices on the rise, most economists believe the Fed must act fast to keep price pressures in check.

Consumers who have already seen price increases may be questioning how it will assist to reduce costs.

The consumer price index increased 7.5% year over year in January, exceeding economists' expectations and marking the highest increase since February 1982. It was also the fourth month in a row that prices rose to new highs.

Tara Sinclair, a senior fellow at the Indeed Hiring Lab, said “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”.

“And then trying to figure out the Fed’s complicated role in all of this is very confusing.” she added.

According to analysts polled by Reuters, the Federal Reserve is anticipated to raise interest rates by a half-point in May and June to combat rising inflation. They also predict a 40% chance of a recession next year.

The mandate of the Federal Reserve

The Federal Reserve's key economic goals are to promote maximum employment, maintain price stability, and maintain reasonable long-term interest rates.

In general, the central bank strives to maintain annual inflation around 2%, a target it missed before the outbreak of the coronavirus, but now must give attention to.

Yiming Ma, an assistant finance professor at Columbia University Business School, said “The Fed’s main tool it can use to battle inflation is interest rates. It does so by setting the short-term borrowing rate for commercial banks, and then those banks pass it along to consumers and businesses”.

This rate affects everything from credit card interest to mortgages and car loans, increasing the cost of borrowing. On the other hand, it increases interest rates on high-yield savings accounts.

Higher rates and inflation

Chief financial analyst at Bankrate, Greg McBride said “The Fed uses interest rates as either a gas pedal or a brake on the economy when needed”... “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”.

The Fed's goal is to make borrowing more expensive so that individuals and businesses delay making investments, therefore reducing demand and restoring price stability.

According to McBride, there could also be a side effect of reducing supply chain concerns, which is one of the key reasons why prices are currently skyrocketing. He added that the Fed can't directly influence or fix supply chain issues.

He said “As long as the supply chain is an issue, we’re likely to be contending with outside wage gains” and this drives inflation.

Likely outcome

Economists are concerned that the Fed increases rates too swiftly and reduces demand too much, stalling the recovery.

If companies stop recruiting or even lay off people to stay solvent, this could result in a higher unemployment rate. If the Fed goes too far with rate hikes, the economy could fall back into recession, stalling and undoing the gains made thus far.

Inflation is treated in the economy in the same way as cancer is treated with chemotherapy, according to Sinclair.

She said “You have to kill parts of the economy to slow things down” … “It’s not a pleasant treatment”.

Any action taken by the Fed will take time to affect the economy and reduce inflation. That's why the Federal Open Market Committee keeps a close eye on economic statistics when deciding how much and how often to boost interest rates.

Surviving increasing interest rate and high inflation

All attention is currently on the Federal Reserve, which is poised to keep raising interest rates in order to keep inflation under control.

In March, the central bank approved a 0.25 percentage point rate hike, with up to six more hikes possible this year. Consumers’ interest rates on credit cards, savings accounts, and mortgages are likely to rise as a result of these increases.

With this in mind, it may be time to reconsider how you manage your balances.

According to Greg McBride, senior vice president, and chief financial analyst at Bankrate.com, efforts to control inflation have experts concerned about the possibility of a recession in 2023 or 2024.

If the economy finally pauses, whatever efforts you make now to pay off debt and increase your savings will benefit you.

“Do so now while the getting is good,” McBride said.

For credit cards

According to McBride, aggressive Fed interest rate hikes have a significant impact on credit card interest rates.

The majority of credit cards are linked to the prime rate. The prime rate rises when the Federal Reserve raises short-term interest rates.

“For the cardholder, your rate will mimic what the Fed does the whole way up,” he said.

If the Federal Reserve is exceptionally aggressive and raises interest rates by three percentage points in the next year and a half to two years, your credit card interest rates will almost certainly rise by the same amount.

“The action step to take now if you’re carrying a balance and trying to get out of debt, trying to insulate yourself from high rates, is to grab one of those low-rate balance transfer offers now” McBride advised.

You'll have an 18 to a 21-month window to pay off your debt while also safeguarding your balance from interest rate hikes.

For savings account

As interest rates rise, online savings accounts will be the most competitive place to put your money.

Interest rates on these accounts range from 0.7% to .75%. Money market funds, on the other hand, are still at 0.1 percent, though their rates are expected to rise as well, according to McBride.

As interest rates climb, you should avoid certificates of deposit, which require you to fix an interest rate for a set period of time.

For mortgages

Following a steep rise that began at the beginning of the year, mortgage interest rates are now around 5%.

According to McBride, this surge is equivalent to another 17% increase in housing prices.

“With the exception of a brief eight-week period in 2018, mortgage rates have been below 5% since 2011,” McBride said. “We’ve been very spoiled by low rates, for sure.”

Many people's chance to refinance their mortgages for higher rates, which many did in 2020 and 2021, has already closed.

On a case-by-case basis, such movements may look right, such as switching from an adjustable or variable rate to a fixed one.