Many people are wondering if the higher interest rates set by the Federal Reserve are slowing inflation. For nine months straight, the annual inflation rate has been decreasing. However, the Consumer Price Index’s (CPI) data will sometimes show specific sectors experiencing price increases despite a general trend of decreasing inflation.
This article will look at what effect the increase in interest rates has had on inflation and what possible negative consequences could be.
Key Takeaways
- The Federal Reserve uses higher interest rates to combat high inflation.
- High inflation has been partly due to the pandemic, government spending, and the Russia-Ukraine conflict.
- Experts often worry that raising interest rates will harm the economy more than help it, but many also argue it’s a necessary step to managing unsustainable growth.
Why Did Interest Rates Rise So Much?
Interest rates dramatically rose in 2022 because of record-high inflation numbers. Inflation spiked due to various factors, including government spending during the pandemic, supply chain issues, historically low interest rates, high energy prices, and the Russia-Ukraine conflict.
Inflation is the devaluation of a country’s currency, usually caused by a mismatch of supply and demand. For example, during the COVID-19 pandemic, the United States government gave out stimulus checks to encourage discretionary spending and reinvigorate the economy. Some experts feared that the checks were boosting demand at a time supply chains were disrupted, pushing companies to raise prices.
If a company faces low demand for a good, it’ll often lower prices to incentivize consumers to buy its product. Conversely, if demand for a product is too high, a company will often raise prices to keep its supply from being overwhelmed.
When inflation began to rise, the Federal Reserve believed the increases were temporary and would come down as quickly as they grew. However, this was not the case, as inflation is still high after many months.
In June 2022, the Consumer Price Index, which measures inflation, peaked at 9.1%. In July, the rate was 8.5%, and in August, it was 8.3%. While the overall number had begun declining, the data within the reports didn’t indicate inflation was cooling off for everyone.
Oil prices dropped throughout 2022, which helped to lower the annual inflation rate, but food and rent costs didn’t initially see the same month-to-month decrease.
Recent numbers
Recent data from the Bureau of Labor Statistics shows the shelter index – including money spent on rented and owned houses – increased 8.2% in March 2023. This was arguably the most significant contributor to the annual inflation rate in March 2023, even as other economic sectors cooled off.
With OPEC+ recently announcing further reductions to its oil production, analysts are warning of higher energy prices in the coming months.
To combat rising inflation, the Federal Reserve uses the primary tool it has—interest rates. Between March 2022 and March 2023, the Fed raised the federal funds rate from near 0% to its current 4.75-5.00%. The Fed’s next meeting will take place between May 2nd and 3rd. We’ll have to wait to see what happens, but many experts anticipate another rate hike of 25 basis points up to 5.00-5.25%.
How Do Higher Interest Rates Slow Inflation?
Higher interest rates slow inflation in several ways. First, higher interest rates make it more expensive to borrow money. The federal funds rate indirectly influences the rate at which banks lend each other money.
Banks have to meet specific reserve requirements related to how much money they keep on hand, so when the fed funds rate increases, the money circulation decreases, and short-term interest rates increase. For consumers, this shows up as higher interest rates on mortgages, auto loans, and credit card debt. When it costs more to borrow money, people will spend less overall.
On the business front, higher interest rates mean businesses will be less likely to borrow money to expand. By slowing down business growth, the economy also slows down.
Another impact of higher interest rates is on savings. The interest rates on savings accounts, certificates of deposit, and bonds will rise, encouraging individuals and investors to save and invest more of their money. The more money they save and invest, the less money they have to spend, decreasing demand.
Combining these two ideas, we can say less consumer demand will ease demand and increase supply. Over time, this should lead to inflation returning to normal levels and the rise of prices stopping. The Federal Reserve aims for an annual inflation rate of only 2%. Even with the annual rate dropping to 5.0% in March 2023, that’s still above the optimal rate.
The caveat to this is time. While increasing interest rates happen in real-time, their effects play out over many months. The potential problem is that even though the Fed has aggressively raised rates, not enough time has passed to see their full impact. The result that some economists fear is a hard landing where rising interest rates push demand so low the economy enters a recession.
What is the difference between a recession and a depression?
A recession is a normal part of the economic cycle and tends to last for a shorter time and have less of a negative impact on most consumers. That doesn’t mean it’s not painful, though, as recessions often lead to increased unemployment, decreased consumer spending, and general anxiety about the economy.
The U.S. has experienced 14 recessions since the Great Depression of the early 1930s. This makes them much more common than a depression, which has only happened once in U.S. economic history.
Experts generally define a depression as a severe drop in GDP lasting more than a year. Most experts date the Great Depression as lasting between 1929 and 1941.
Do Higher Interest Rates Work to Slow Inflation?
Many people, including legislators, are skeptical of whether increasing interest rates can slow inflation. For example, we can look at an exchange that happened in June 2022 during the Semiannual Monetary Policy Report to Congress.
Senator Elizabeth Warren (D-Massachusetts): “Chair Powell, will gas prices go down as a result of your interest rate increase?”
Chairman Powell “I would not think so, no.”
Senator Warren: “Chair Powell, will the Fed’s interest rate increases bring food prices down for families?”
Chairman Powell “I wouldn’t say so, no.”
Senator Warren: “The reason I raise this and the reason I’m so concerned about this is rate increases make it more likely that companies will fire people and slash hours to shrink wage costs. Rate increases also make it more expensive for families to do things like borrow money for a house. And so far this year, the cost of a mortgage has already doubled.
“Inflation is like an illness. And the medicine needs to be tailored to the specific problem. Otherwise, you could make things a lot worse. And right now, the Fed has no control over the main drivers of rising prices, but the Fed can slow demand by getting a lot of people fired and making families poorer.”
Food and shelter prices
It’s very reasonable to ask why things like food and shelter prices shouldn’t decrease from higher interest rates. If higher interest rates increase saving and reduce demand, shouldn’t that lower the cost of everything?
Experts believe that rising interest rates don’t always have as much impact on these sectors because their prices are affected by more than one factor.
For example, one leading cause of higher food costs in 2022 was supply chain issues. The food supply needed to increase to combat this, and agricultural commodities have since seen a price drop. Also, if businesses stop hiring or cut workers’ hours, they won’t be able to produce as much, decreasing the supply further.
The main idea with higher interest rates is to slow demand, but demand for food can only decrease so much. It’s a basic necessity and isn’t always impacted by reduced discretionary spending.
There is also no clear correlation between interest rates and shelter prices. Though rental prices should ideally decrease when rates are high as demand has dropped, they may increase as the cost of borrowing money for landlords and property developers increases.
Government spending
If we look at the government, the money it spends also significantly impacts inflation. If the government chooses not to reduce spending, the increase in interest rates will have minimal effect.
Leonardo Melosi of the Chicago Fed and Francesco Bianchi of Johns Hopkins University say, “The recent fiscal interventions in response to the COVID-19 pandemic have altered the private sector’s beliefs about the fiscal framework, accelerating the recovery but also determining an increase in fiscal inflation. This increase in inflation could not have been averted by simply tightening monetary policy.”
The Bottom Line
The Federal Reserve’s primary tool to fight inflation is increasing interest rates. While higher rates impact prices, inflation doesn’t disappear overnight. This can spell trouble for the U.S. economy since raising rates too quickly can lead to a recession.
Additionally, without the government reducing spending, the increase in interest rates might have minimal effect on inflation. The upcoming months will give us more insight into whether higher interest rates are or aren’t working.
With oil prices likely heading higher, the monthly inflation report won’t be able to rely on lower oil prices offsetting increased costs elsewhere. If everything rises and inflation doesn’t continue to cool off, the Fed will likely resume raising interest rates.
