How raising interest rates helps fight inflation and high prices
The Federal Reserve increased its key interest rate 11 times since March 2022 as it tries to tame consumer goods prices.
Get more news Live
June 16, 2022, 6:31 PM EDT / Updated July 12, 2023, 9:06 AM EDT
The Federal Reserve raised its key federal funds rate 11 times since March 2022 — something it hasn’t done as aggressively since the 1980s.
The central bank hopes that by doing so, it can slow down the economy enough to moderate price growth.
But how does raising interest rates do that, exactly?
When you get a loan from a bank — for example, when you’re buying a house — an interest rate is attached to that loan. The interest rate is the price you pay to borrow the money.
Banks need to borrow money, too. Instead of borrowing directly from other banks, they look to the Federal Reserve — America’s central bank. Its primary role is to provide a safe and reliable financial system for the U.S. by maintaining deposit accounts for banks.
When banks need to borrow money, they look to other banks that have deposit accounts with the Fed that may be in a surplus.
And just as with any other loan, the banks are charged an interest rate for borrowing money. It is this percentage, known as the federal funds rate, that the Federal Reserve helps set with its interest rate announcements.
How the federal funds rate influences parts of the economy
But how could one interest rate have so much influence on the broader economy?
Banks pass on the cost of a higher federal funds rate to their customers when those customers want to access regular lending products.
The best example is the prime rate. This is the interest rate banks charge their most creditworthy borrowers, like large corporations. For several decades now, the rule of thumb has been that the prime rate is equivalent to the federal funds rate plus 3%. So, with the new federal funds target rate at between 5.25% and 5.5%, the new prime rate at the upper range would be at 8.5%. The percentage difference is supposed to cover the cost of processing a bank loan.
Changes in the prime rate, in turn, drive up the cost of borrowing for all other loan products, like real estate and vehicle purchases, as well as revolving debt such as credit cards. The 30-year fixed mortgage rate hovered above 7% in July.
As the theory goes, if it’s more expensive to borrow money or carry a balance on a credit card, consumers will spend less. When spending declines, demand will fall and, eventually, so will the price of everyday goods.
There is a risk, however. Economists warn the combination of higher borrowing costs, high inflation, and slower growth could tip the U.S. economy into a recession. So the onus is on the Federal Reserve to choose its moves carefully.
Does raising interest rates actually work?
Federal Reserve chairman Jerome Powell has said he is seeking to bring demand more in line with supply. But the global supply chain for a wide array of products has been severely constrained over the course of the pandemic, due in part to strict Covid-19 policies in China where many mass-produced goods are sourced.
The ongoing war in Ukraine has negatively affected the global food supply in addition to the crude oil and natural gas resources that Europe largely depends on.
So, there may only be so much the Federal Reserve can do with the tools it has available.
“Goods inflation is a trade and geopolitics issue that’s controlled by government as a whole and not the Fed,” said Derek Tang, an economist at LH Meyer Inc., a macroeconomic consulting group.
“We’ll have to look to the White House and Congress to act on those issues, whether that means brokering deals with other countries to make sure we have better supply, or have more access to supply,” Tang said.
Rob Wile is a Pulitzer Prize-winning journalist covering breaking business stories for NBCNews.com.
How does raising interest rates affect inflation?
Interest rates can have a real impact on inflation. Learn how it works and what changing interest rates could mean for you.
September 20, 2024
When inflation is on the rise, everything from groceries to gas can get more expensive. And while a little inflation is normal, the Federal Reserve Board (also known as “the Fed”) tries to prevent steep increases in prices. Inflationary spikes can occur due to several factors, including supply chain issues, a booming labor market, and a low interest rate environment.
The Fed monitors inflation by tracking the average costs of goods and services. One of the most relied-upon measures of inflation is the Consumer Price Index (CPI), which looks at common expenses like food, energy, transportation, shelter, and health care.
When inflation is high, as it was in 2021 and 2022—with the headline number peaking in June 2022 at 9.1%, per a Bankrate article citing the Bureau of Labor Statistics (BLS)—consumers’ dollars don’t go as far because goods and services are more expensive. This not-so-fun reality tends to put a damper on economic growth, and people with a lower income are disproportionately burdened because they cannot afford higher prices. But it’s not a great situation for anyone.
So, how does raising interest rates affect inflation? Learn why inflation can happen in the first place and how it can impact your online bank accounts.
Why has inflation been so high?
The pandemic sparked a chain of events—including supply chain disruptions, disruptions in production, and pandemic stimulus packages, per Bankrate—that helped lead to the inflationary spike between 2021 and 2022.
First, the global supply chain, which encompasses all stages of manufacturing, assembly, and logistics that make it possible for goods to be delivered around the globe in a timely fashion, was severely impacted by illness, business closures, and travel restrictions, per Bankrate. Simultaneously, demand for goods increased as people—many working from home—began ordering more things online to be shipped directly to their front doors.
It’s economics 101: When demand goes up and supply goes down, prices rise. And that causes inflation.
Then, as the pandemic started to ease, another event that would lead to price shocks occurred: Russia’s invasion of Ukraine. Russia is a major supplier of the world’s oil. As more countries placed war-related sanctions on Russia, oil prices rose—a lot. According to Bankrate, the price of a barrel of oil nearly doubled from February 2022 (when the war began) to July 2022.
Meanwhile, the upward trajectory of a robust job market and a roaring stock market in the U.S. meant that many consumers could afford to pay higher prices at the stores and the pumps. This combination of forces can propel prices even higher and keep economists and policymakers at the Fed up at night.
Since its peak in 2022, inflation has cooled in 2024, according to Bankrate.
Luckily, the Fed has a tool to combat runaway inflation: interest rates.
What happens to inflation when interest rates rise?
The Federal Reserve’s job is to keep inflation manageable so that consumers are encouraged to spend and save. Interest rates—which represent the cost of borrowing money—are reflected in the annual percentage yields (APYs) of savings accounts and mortgage rates. (Learn more about how the Federal Reserve can affect mortgage rates.)
How does raising interest rates affect inflation?
When interest rates go up, borrowing money gets more expensive. How does this increase in interest rates affect you? Mortgages, car loans, and business loans aren’t as attractive. As a result, fewer consumers are willing to take out loans to buy or invest in things. Higher interest rates tamp down demand, which usually leads to a dip in prices as well.
Consumers are affected in other ways, too. Because interest rates on savings accounts, certificates of deposit (CDs), and money market accounts tend to increase, people move more of their money into these savings products to reap the benefits. Here’s how raised interest rates can affect those different accounts:
Impact of raised interest rates on savings accounts
Banks’ interest rates typically track what the Federal Reserve is doing. So if you’re wondering when savings account interest rates will go up, it’s usually after a Fed rate hike. Money in a high-yield savings account during periods of higher interest rates will yield more returns as your funds compound over time.
Impact of raised interest rates on CDs
CDs offer a guaranteed interest rate for the entire term of the CD, no matter what is happening in the stock market or if interest rates are rising (or falling). That said, these savings vehicles are especially beneficial when CD rates are high because you can lock in that rate over a set period—typically between three months and 10 years.
Choose your term, lock in your rate, and watch your CD grow
Discover, a division of Capital One,
N.A., Member FDIC
Impact of raised interest rates on money market accounts
Money market accounts also benefit from higher interest rates. They can feature an APY that’s competitive with savings accounts, but they can also include a debit card like a checking account for easy access to your money. To get the most out of a money market account, choose one with a high APY that doesn’t include fees.
“When demand goes up and supply goes down, prices rise. And that causes inflation.”
When will inflation go down?
Inflation doesn’t last forever. As cited above, after a series of interest rate hikes by the Fed, inflation had simmered down to 2.5% by August 2024, according to Bankrate.
Keep saving through the ups and downs of inflation despite interest rate fluctuations
Though no one knows for sure when inflation will go up or down, here’s one piece of advice that’s always wise during uncertain economic times: Stay the course. That means continuing to save for retirement and spend money wisely to make your financial goals a reality.
Looking for a safe place to keep your savings that also offers a high interest rate so your money can grow over time? Look no further than a high-yield online savings account.
Articles may contain information from third parties. The inclusion of such information does not imply an affiliation with the bank or bank sponsorship, endorsement, or verification regarding the third party or information.
The information provided herein is for informational purposes only and is not intended to be construed as professional advice. Nothing contained in this article shall give rise to, or be construed to give rise to, any obligation or liability whatsoever on the part of Discover Bank or its affiliates.
https://www.nbcnews.com/business/economy/how-raising-interest-rates-helps-fight-inflation-high-prices-recession-rcna33754https://www.discover.com/online-banking/banking-topics/how-does-raising-interest-rates-affect-inflation/