What is the purpose of the Federal Reserve raising interest rates to combat inflation?

On Wednesday, the Federal Reserve will declare its first interest rate increase since 2018.

The federal funds rate target may increase by 25 basis points due to the worst inflation in over 40 years, which was partly caused by the pandemic. A basis point is equivalent to 0.01%.

Consumers facing higher prices may be questioning how rising borrowing costs can reduce inflation.

In February, the consumer price index reached a 7.9% annual rate, the highest since January 1982, due to rising costs of items such as food and fuel, which further eroded any wage gains workers may have seen in the last year.

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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 Fed aims to maximize employment, control inflation, and maintain moderate long-term interest rates.

The central bank aims to maintain an annual inflation rate of approximately 2%, which fell behind the target before the pandemic.

Yiming Ma, an assistant finance professor at Columbia University Business School, stated that the main tool to combat inflation is interest rates. This is achieved by setting the short-term borrowing rate for commercial banks, which then gets passed along to consumers and businesses.

The higher interest rate affects both borrowing and saving, with borrowing becoming more expensive and savings rates increasing.

Interest rates and the economy

According to experts, how do higher interest rates combat 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, potentially lowering prices.

McBride stated that although the central bank can't directly address supply chain issues, it could indirectly help alleviate them, which may contribute to lowering prices.

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

What the Fed wants to avoid

The concern of economists is that the Fed increases interest rates too rapidly, which may reduce demand excessively and hinder the economy's growth.

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

Sinclair of the Indeed Hiring Lab 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 and its impact on the economy.

The war in Ukraine has caused an increase in commodity prices, including gas, and the Fed must monitor the impact on the U.S. economy and take appropriate action.

It might get worse before it gets better

Sinclair stated that when the Fed raises rates, it is likely that people will observe the negative consequences of those increases before any positive impact on inflation.

The situation where borrowing money becomes more expensive and gas and grocery prices continue to rise poses a challenge, especially for low-income workers whose wages have not kept up with inflation.

The central bank aims to gradually increase interest rates to slow the economy and reduce inflation without causing excessive unemployment.

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

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