How Does Raising Interest Rates Help Inflation?

Rising prices can stir worries that inflation will escalate into something difficult or impossible to tame. So before it gets out of control, the Fed asks us to temporarily trade one pain for the other.

In short: The Federal Reserve raises interest rates to slow the economy. By making it more costly to borrow and spend, rate hikes discourage borrowing and spending. This lowered demand theoretically slows inflation.

Is this what’s happening now? That depends on which economist you ask.

Inflation is coming down; that much is clear. But the causes are less clear. Consumer demand (that borrowing and spending mentioned above) isn’t the only driver of price growth. The slowing inflation we’re seeing now could also be due to the unwinding of pandemic supply chain kinks and the Russian invasion of Ukraine — the further we get from economic shocks like that, the less their impact is felt.

The causes of recent inflation and disinflation will be the topics of analysis for years to come. For now, let’s look at what the Fed is hoping to accomplish with higher rates.

In short: The Federal Reserve uses monetary policy to influence the economy in hopes of maintaining 2% inflation, or prices that grow 2% year over year as measured by the personal consumptions expenditure index, or PCE.

The job of the Federal Reserve, as the nation’s central bank, is to enact monetary policy. It’s been doing this in one form or another since 1913. Monetary policy boils down to actions taken to influence the supply and cost of money in order to further economic goals. The Fed uses three tools to do this:

• Setting the interest rate that the Fed charges on loans to banks (called the “discount rate”).

• Telling banks how much cash they must have on hand (“reserve requirements”).

• Conducting open market operations.

It’s this last bit — open market operations — that includes influencing interest rates to control inflation. This is the job of the Federal Open Market Committee (FOMC), currently led by Fed Chairman Jerome Powell.

The Fed has a two-part mandate: Seek maximum employment and low, stable inflation. We expect prices to grow over time. But low, steady growth promotes economic stability, whereas high, rapid inflation decreases purchasing power, straining households and businesses. The Fed began targeting an annual inflation rate of 2% specifically in 2012. Before then, “low” was a little less prescriptive.

But why 2%? Maintaining a slightly positive inflation rate generally goes hand-in-hand with a slightly positive interest rate. Slightly positive is preferable to zero because sometimes the Fed wants to reduce interest rates to stoke the economy. If the federal funds rate is at zero, the Fed’s hands are tied.

The primary way the FOMC encourages low, stable inflation is by setting a target for what’s called the federal funds rate.

In short: A change in the target federal funds rate affects interest rates throughout the economy. Raising it makes borrowing (and therefore spending) money more expensive, reducing consumer demand. Less demand equals less fuel for demand-driven price increases.

The federal funds rate is an interest rate paid by banks to other banks for overnight loans. The Fed doesn’t set this rate directly, but does limit it by changing the rate it pays to banks on their reserve balances. So when the FOMC announces a change to the target federal funds rate, what the committee is really announcing is a direct change to its reserve rate, which will influence banks to change the rate they charge each other. The Fed targets a specific change in that interbank rate, through its influence on reserves.

A change in the rate that banks charge each other for overnight loans motivates other rate fluctuations across the economy, most directly on short-term loans and credit lines (including the rate you pay on your credit card balance). Longer-term interest rates also increase, through a combination of the rise in the federal funds rate and people’s expectations of where the economy is headed. In fact, rates on long-term loans like mortgages sometimes anticipate Fed movements, changing before a higher target federal funds rate is announced.

Throughout the economy, higher rates change behaviors. A few examples:

• When credit card interest goes up, you may spend less using your card or make cuts elsewhere in the household budget to continue making your (now-higher) payments on carried balances. 

• If homes were already pricey in your area, a change from 3% to 7% mortgage rates may be the impetus for continuing to rent. 

• Small businesses (and even some larger corporations) may delay expansions due to higher funding rates. And higher rates also affect demand by encouraging savings — interest rates on savings accounts and certificates of deposit, for example, entice people to set their money aside.

These effects take time to work their way into the economy, but ultimately impact the motivations and abilities for consumers and businesses to borrow, spend and invest. This demand (money changing hands throughout the economy) can be thought of as the fuel for some price growth. By forcing the proverbial foot to ease off the gas, that growth slows.

In short: The effects of monetary policy are not swift or easily spotted. Many factors can influence price growth, and the Fed’s impact on rates is one of few the central bank exercises any control over.

The impact of monetary policy hits the economy with “long and variable lags,” a phrase coined by Nobel Prize winning economist Milton Friedman. Prices may not show the impact of Fed policy for 18 to 24 months. Spotting these effects with any certainty would require the ability to remove other influences on the economy, a difficult exercise. Inflation may come down after rates are raised, but rates aren’t the only thing affecting the changes we see. Price growth can also slow as we get further away from economic shocks (like COVID-related supply chain disruptions) and massive cash infusions (like the pandemic stimulus payments from the federal government).

In a rate-raising campaign, the FOMC is not only watching inflation numbers, but data from across the economy. The committee wants to be certain inflation is coming down, but gently. From past experience, the Fed knows that not being aggressive enough could lead to runaway inflation, but slowing the economy too much could lead to recession. So it’s a delicate dance that always stands to be upended by unforeseen shocks — such as a pandemic or natural disaster.