How Interest Rates Can Cool Inflation

The Federal Reserve has raised interest rates in 2022 after more than two years of keeping rates steady, at a very low level. The Fed increased the interest rate by 0.5% in March 2022 and by another 0.5% in May 2022 to cool the economy and bring inflation under control. This raises the question: How does hiking interest rates help curb inflation? We explore how interest rates and inflation intertwine and what you need to know.

A financial advisor can help you respond with your investments and savings to either inflation or rising interest rates.

What Is Inflation?

Inflation is the rate of increase in the price of goods and services over time. In other words, inflation is more about price trends observed within the economy as a whole rather than looking at a single product or even a handful of products. The most popular measure of inflation is the consumer price index (CPI). It uses 80,000 items in a fixed basket of goods and services and captures what Americans buy every month. This includes everything from groceries to TV subscriptions.

CPI is not the only measure of inflation, however. There are CPI variants, such as CPI-U, which measure the overall prices for urban consumers. There is also the index for personal consumption expenditures (PCE), which is an index that comes from the Bureau of Labor Statistics (BLS). The PCE includes additional costs, such as a broader measure of healthcare expenditures than the CPI captures. The Fed uses PCE as its measure of inflation, not CPI.

What Causes Inflation?

Inflation can be complicated and rarely is it caused by a single factor. However, basic economics tells us that supply and demand dictate prices in a free market economy. That is, prices will rise if demand increases without a proportional increase in supply, or if supply falls without a proportional decrease in demand.

In 2022, for example, households had excess savings that they built during the pandemic, thanks in significant measure to. Some of that came from federal government stimulus checks, such as the $3.7 trillion Washington spent to fight the effect of Covid. Some of it came, post-COVID, from people resuming their previous lives, and demand for products surged and supply chains couldn’t keep up.

How Interest Rates Can Cool Inflation

When interest rates rise, it becomes more costly to borrow money. This leaves consumers with less money in their pockets, and they spend less as a result. This might cause grocery shoppers to prefer the generic brand over the name brand or spend less on non-essentials. It also affects business spending, which is sensitive to the cost of money. So rising interest rates tends to dampen both individual consumer spending and business activity.

If all goes well, the result of raising the interest rate will be a cooling effect on the economy, causing the interest rate to fall back in line. The goal is not for inflation to be zero but to be about 2% because the Fed sees this as a healthy rate of inflation for a growing economy.

Thus, rising interest rates are an attempt to bring the economy back into equilibrium. The expectation is that the prices of many items will fall, including your everyday goods such as gas and groceries. However, the question is whether the Fed can walk this fine line of raising the interest without raising them too much, too quickly. This is sometimes referred to as a “soft landing.”

The ‘Soft’ Landing

When the Fed raises rates, it often aims to make a skillful soft landing. A soft landing refers to the Fed raising interest rates just enough without causing a recession. This happened when the Fed rose interest rates to nearly 20% under Paul Volcker, who served as Fed chair from 1979 until 1987.

While Volcker did bring inflation under control, it went from 13.5% in 1980 to just 3.5% in 1983, but it came at a cost. The economy was thrown into a recession and the unemployment rate increased dramatically, from 6% in 1979 to over 10% in 1982.

In general, if the Fed wants to bring inflation under control, it aims to do so without plunging the economy into a recession. However, as Lawrence H. Summers, professor at the Harvard University Kennedy School, and Alex Domash, a research fellow at the Kennedy School, wrote in an article for The Conversation, the soft landing is easier said than done.

According to Summers and Domash, high inflation rates and low unemployment are strong indicators of future recessions “In fact, since the 1950s, every time inflation has exceeded 4% and unemployment has been below 5%, the U.S. economy has gone into a recession within two years.”

In April 2022, the unemployment rate in the U.S. was 3.6% and the inflation rate was 8.3%. Based on those figures, the Fed may have its work cut out for it in order to put the economy into a better position.

Bottom Line

If consumers have a lot of money to spend, they can sometimes put a strain on supply chains, leading to rising prices. The Fed tends to respond to this situation by raising interest rates, which makes it more expensive to borrow money. This leaves people with less money to spend, with the goal of bringing inflation under control.

Tips for Rising Inflation

• With inflation and raising interest rates, there can be a lot of concerns over how these types of activities impact your finances. You can speak with a financial advisor to make a plan that will help you through good and bad times. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.

• Rate hikes tend to mean higher APRs on credit cards. Thus, if you have a lot of credit card debt, it’s a good idea to pay your balances down when rate hikes are anticipated. Use SmartAsset’s credit card calculator to figure out how long it will take to pay off your credit cards at your current pace.

• The rates for 30-year home mortgages also tend to increase when inflation is rising. If you are thinking about buying a new home, you may want to see what the mortgage rates are before going all in. Our tool can help you find the mortgage rates near you.

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