Many people wonder if the Federal Reserve's higher interest rates are slowing down inflation. The annual inflation rate has decreased for nine consecutive months. The Consumer Price Index (CPI), however, can sometimes show that specific sectors are experiencing higher prices despite the general trend of decreasing inflation.
This article will examine the impact of interest rate increases on inflation, and possible negative effects.
The Key Takeaways
Many experts worry that increasing interest rates could harm the economy rather than benefit it. However, many argue it is a necessary step in managing unsustainable growth.
Why did interest rates rise so much?
In 2022, interest rates rose dramatically due to the record-high numbers of inflation. The spike in inflation was due to a number of factors including the government's spending during the pandemic and supply chain problems, historically low rates of interest, high energy costs, and the Russia/Ukraine conflict.
Inflation is a devaluation in a currency's value, which can be caused by mismatches between supply and demand. During the COVID-19 epidemic, for example, the United States gave out stimulus checks in order to stimulate discretionary spending. Some experts were concerned that the checks would boost demand during a period when supply chains were disrupted and push companies to increase prices.
A company will often lower its prices if it is experiencing low demand for the product. This is done to encourage consumers to purchase that particular product. In the opposite case, if a product's demand is high, companies will raise their prices to prevent being overrun.
The Federal Reserve thought that when inflation started to increase, it would be temporary and will fall as fast as it grew. This was not true, since inflation has remained high for many months.
In June 2022 the Consumer Price Index (which measures inflation) peaked at 9.1%. In August, the rate was 8,3%. In July, it was 8,5%. The overall rate of inflation had started to decline, but the data in the reports did not indicate that everyone was experiencing a decrease.
Food and rent prices did not initially decrease at the same rate month-to-month as oil prices.
According to Bureau of Labor Statistics data, the housing index (which includes money spent on both rented and owned homes) increased by 8.2% in march 2023. The housing index was the largest contributor to the March 2023 annual inflation rate, even though other economic sectors were cooling off.
Analysts warn that energy prices will rise in the months to come after OPEC+ announced further cuts to its oil production.
The Federal Reserve's primary tool to combat inflation is interest rates. The Fed increased the federal funds rates from near 0% in March 2022 to 4.75-5.00% today. The Fed will hold its next meeting between May 2nd - 3rd. Many experts predict another 25 basis point rate hike up to 5.00 to 5.25%.
How do higher interest rates slow inflation?
Inflation is slowed by higher interest rates in several ways. Higher interest rates increase the cost of borrowing money. Federal funds rate influences indirectly the rate that banks lend money to each other.
When the Fed Funds rate rises, banks must meet certain reserve requirements relating to the amount of money they have on hand. Short-term interest rates therefore increase when money circulation falls. This is reflected in higher interest rates for mortgages, auto loan and credit card debt. People will spend less if borrowing money costs more.
Higher interest rates will make it less likely that businesses will borrow money for expansion. Slowing business growth will also slow down the economy.
Savings are also affected by higher interest rates. Interest rates on certificates of deposit and savings accounts will increase, encouraging investors and individuals to save more money. Saving and investing more money will reduce demand because the amount of money available to spend is reduced.
We can combine these two ideas to say that less consumer demand will increase supply and ease demand. This should eventually lead to the inflation returning to its normal level and prices no longer rising. The Federal Reserve targets an annual inflation rate below 2%. Even if the rate drops to 5.0% by March 2023, it's still higher than the ideal rate.
Time is the caveat. While the effects of increasing interest rates are felt immediately, they take many months to manifest. Even though the Fed raised rates aggressively, there has not been enough time to observe their full effect. Some economists are worried about a hard landing, where the rising interest rates will push demand to such a low level that the economy will enter a recession.
What is the distinction between a depression and a recession?
A recession is part of the normal economic cycle. It tends to be shorter and has a less negative impact on consumers. It doesn't make it any less painful. Recessions can lead to higher unemployment, lower consumer spending and anxiety over the economy.
Since the Great Depression in the early 1930s, the U.S. experienced 14 recessions. The U.S. has experienced 14 recessions since the Great Depression of the early 1930s.
Experts define a depression by a significant drop in the GDP that lasts more than one year. The Great Depression was largely dated between 1929 and 1941 by most experts.
Does increasing interest rates slow inflation?
Many people, even legislators, doubt that increasing interest rates will slow inflation. We can, for example, look at an interaction that took place in June 2022 when the Semiannual Monetary Policy Report was presented to Congress.
Senator Elizabeth Warren (D Massachusetts): "Chair Powell will gas prices drop as a result your rate hike?"
Chairman Powell: "I don't think so."
Senator Warren: "Chair Powell will the Fed's increased interest rates bring down food prices for families?"
Chairman Powell "I would not say that, no."
Senator Warren: "The main reason why I bring this up and why I am so concerned is that rate increases increase the likelihood of companies firing people and cutting hours in order to reduce wage costs. The cost of borrowing money to buy a home is also more expensive when rates increase. The cost of a home mortgage has doubled in the past year.
"Inflation like a disease. The medicine must be adapted to the problem. You could make the situation worse if you don't. The Fed cannot control the price rises, but it can reduce demand by laying off a large number of workers and making the families poorer.
Prices of food and shelter
It is reasonable to wonder why prices of food and housing don't drop with higher interest rates. Shouldn't higher interest rates lower prices if they increase savings and reduce demand?
Experts say that these sectors are not as affected by rising interest rates because they are affected by multiple factors.
Supply chain problems, for example, were a major cause of rising food prices in 2022. To combat this, the food supply had to be increased. Since then, agricultural commodities have seen a drop in price. If businesses cut back on hiring staff or reduce their hours, then they will not be able produce as much and this will further decrease the supply.
Higher interest rates are meant to slow down demand. However, the demand for food is limited. Food is a necessity that's not always affected by lower discretionary spending.
It is not clear whether interest rates are related to shelter prices. Rent prices are likely to increase when interest rates are high, as demand is down. However, this may be due to the increased cost of borrowing for property developers and landlords.
Spending by the Government
The money that the government spends has a significant impact on inflation. The increase in interest rate will be minimal if the government does not reduce its spending.
Leonardo Melosi, of the Chicago Fed, and Francesco Bianchi, of Johns Hopkins University, say that "the recent fiscal interventions as a response to the COVID-19 epidemic have changed the private sector's belief about the fiscal frame work, accelerating recovery, but also determining a rise in fiscal inflation." The increase in inflation was not averted simply by tightening the monetary policy.
The Bottom Line
Inflation is fought by increasing interest rates, which is the primary tool of the Federal Reserve. Although higher rates affect prices, inflation does not disappear overnight. This could be a problem for the U.S. economic system, as raising rates too rapidly can cause a recession.
The increase in interest rates may have a minimal impact on inflation if the government does not reduce spending. In the coming months, we will have a better idea of whether or not higher interest rates work.
Oil prices are likely to rise, so the monthly inflation report will not be able rely on lower prices of oil offsetting higher costs elsewhere. The Fed is likely to resume raising interest rate if inflation continues to rise and nothing changes.