Raising interest rates could help combat the 40-year high inflation.

This year, the Federal Reserve plans to increase interest rates for the first time since 2018 in an effort to combat the severe inflation caused by the COVID-19 pandemic.

May consumers, who are already facing higher prices, be wondering how it will alleviate the increase in costs?

The consumer price index experienced a 7.5% increase in January compared to the previous year, exceeding economists' predictions and being the fastest rise since February 1982. This increase was the fourth consecutive month in a row.

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Tara Sinclair, a senior fellow at the Indeed Hiring Lab, stated that understanding the rapid price increases, which are unfamiliar to many people who have not experienced inflation rates like these before, is challenging for the typical consumer. Additionally, comprehending the Fed's intricate role in this situation is also perplexing.

Here’s what you need to know.

The Fed’s mandate

The Federal Reserve aims to achieve three primary objectives in the economy: full employment, price stability, and moderate long-term interest rates.

The central bank must now address the lagging benchmark of keeping inflation around 2% annually, which it had before the pandemic.

Yiming Ma, an assistant finance professor at Columbia University Business School, stated that the Fed's primary weapon against inflation is interest rates. By setting the short-term borrowing rate for commercial banks, the Fed causes these banks to pass the rate along to consumers and businesses.

The rate affects both borrowing and saving, with higher rates making borrowing more expensive and increasing the interest earned on high-yield savings accounts.

Higher rates and the economy

How do higher interest rates curb inflation? By slowing down the economy.

According to Greg McBride, chief financial analyst at Bankrate, the Fed employs interest rates as a tool to either accelerate or slow down the economy. In the current scenario, with high inflation, the Fed can increase interest rates to curb inflation.

The Fed aims to increase borrowing costs to discourage investments and reduce demand, ultimately lowering prices.

Although the Fed can't directly address supply chain issues, it could indirectly help alleviate them, said McBride.

If the supply chain remains a problem, we can expect to face inflation due to outside wage increases, he stated.

What could go wrong

The concern of economists is that the Fed increases interest rates too rapidly, which may hinder demand and impede the economic recovery.

If businesses stop hiring or lay off workers, it could lead to a higher unemployment rate. If the Fed overshoots rate hikes, it could push the economy back into a recession, halting and reversing the progress made so far.

Sinclair compared treating inflation in the economy to treating cancer with chemotherapy.

"Slowing down the economy requires sacrificing certain parts of it, which is unpleasant," she stated.

The Federal Open Market Committee closely monitors economic data to determine the appropriate time and frequency to increase interest rates in order to reduce inflation.

Things could get worse before improving

It is uncertain how much the first interest rate hike will be and what will follow it, as the Fed has only signaled that it is likely to raise rates in March.

In March, markets increased their pricing by 50 basis points, or 0.5%, but have not yet agreed on any additional increases.

On Monday, St. Louis Fed President James Bullard stated that he believes the Fed should raise interest rates promptly.

Bullard stated on CNBC's "Squawk Box" that he believes more of the planned removal of accommodation should be front-loaded due to the unexpectedly high inflation.

This week, Bullard stated in an interview with Bloomberg News that he believes the Fed should raise rates by up to 1 percentage point by July. While other regional bank leaders want to start raising rates in March, none are as aggressive as Bullard.

Sinclair predicted that when the Fed raises interest rates, people will see the negative effects of those increases before any positive impact on inflation.

At first, consumers may have to pay more to borrow money and still see inflated prices at the gas pump and grocery store, which is particularly harmful for low-income workers who have seen wages go up recently but not keep pace with inflation.

The Fed aims to gradually increase interest rates to slow down the economy and reduce prices, while minimizing the impact on unemployment.

“They have to carefully walk that tightrope,” said Sinclair.

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