Why Does Raising Rates Slow Inflation?

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WASHINGTON, DC - JUNE 23: Jerome Powell, Chairman of the Board of Governors of the Federal Reserve System testifies before the House Committee on Financial Services June 23, 2022 in Washington, DC. Powell testified on monetary policy and the state of the U.S. economy.
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The Balance is here to help you navigate your financial life. To that end, we track the money-related questions you most search on Google so we know what’s on your mind. Here’s the answer to your latest question about interest rates and inflation.

Why does raising rates slow inflation? 

Raising interest rates, as the Federal Reserve has been doing since March, reduces economic activity by taking buying power away from consumers and businesses, and that helps slow inflation.

When the Fed hikes its benchmark interest rate, called the fed funds rate, borrowing costs go up for all kinds of loans, including interest rates on car loans and credit card debt. Indirectly, it also makes mortgage rates go up. But why is it believed this will help bring down inflation? After all, don’t higher borrowing costs make it more expensive to buy things on credit, not less?

It all comes down to the economic law of supply and demand. Many economists say that inflation—currently running at an annual rate of 8.6%, the highest in four decades—is basically a problem of “too much money chasing too few goods.” The pandemic, the Russian invasion of Ukraine, and a persistent labor shortage have all been disrupting normal commerce. And since the Fed is unable to create more goods (or services) to meet the demand, its only option is to tackle the “money” part of the equation by crimping its supply.

The idea is that consumers will buy less stuff and businesses will invest in less equipment and hire fewer workers when it’s more expensive to borrow money. As a result, prices should stop skyrocketing since there’s less competition for goods and services. However, this strategy comes with the serious risk of slowing the economy down so much that it causes a recession—something economists believe is increasingly possible as the Fed continues its campaign of rate hikes.

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