The Fed Just Raised Interest Rates By .75 Points. Here’s How That Helps Fight Inflation

It’s been a difficult year for the U.S. economy. While consumer spending remains strong, and there are nearly twice as many open jobs as people looking for work, inflation is at its highest level in decades.

But the Federal Reserve, which sets the nation’s monetary policy, took another step in its attempt to curb those economic strains on Wednesday by raising interest rates three-quarters of a percentage point for the fourth time this year. High rates of inflation have persisted despite the Fed’s efforts so far, but officials hope the move will slow down the economy and set off a cascade that leads to lower consumer prices, which have climbed on everything from groceries to cars to rent.

“Without price stability, the economy does not work for anyone,” Jerome Powell, the Fed’s chair, said at a press conference on Wednesday. “Despite all the inflation, longer term expectations appear to remain well anchored… But that is not grounds for complacency. The longer the current bout of high inflation continues, the greater the chance that expectations of higher inflation become entrenched.”

The move brings the Fed’s policy rate to 3.75% to 4%, its highest point since Dec. 2007, which economists consider the “restrictive territory” due to the heightened risk of forcing the economy to slow down too much, causing a recession. Even so, interest rate hikes are known as the central bank’s one major tool to lower inflation, which it does by raising the cost of borrowing money to curb the demand for goods and services. Economists won’t know until later if the Fed’s moves were successful or not.

In the meantime, consumers and businesses will find it more expensive to borrow from banks, as interest rates rise on everything from auto loans to mortgages.

Why does the Fed increase interest rates?

In short, the Fed hopes its rate hikes will temper demand for consumer goods and services by making it more expensive to borrow money.

The philosophy is that if goods and services become too pricey, less people will buy them, and sellers will have to lower their prices to retain customers. For example, a car dealership may be forced to slash the price on a new car if potential buyers are unwilling to pay the extra interest rates for auto loans.

It may sound like a simple formula, but the reality is much more complicated. The Fed envisions bringing inflation down to about 2%—its preferred pace of price rises across the economy—from its current rate of 8.2%. The challenge is that the Fed doesn’t have many levers to pull to achieve that goal.

A host of factors are combining to make the Fed’s fight against inflation particularly difficult. “Job gains have been robust in recent months, and the unemployment rate has remained low. Inflation remains elevated, reflecting supply and demand imbalances related to the pandemic, higher food and energy prices, and broader price pressures,” the central bank said in a statement Wednesday. It also pointed to Russia’s war against Ukraine, which it said “is causing tremendous human and economic hardship. The war and related events are creating additional upward pressure on inflation and are weighing on global economic activity.”

The economy is facing a number of constraints beyond companies overcharging for the products they sell, including shortages of semiconductors and available workers, also impacting consumer behavior. The Fed can discourage people from getting a new auto loan, but it can’t boost production of semiconductors. Some economists warn that it would take a giant decline in demand to bring the economy back into balance, but that could lead to a recession in which more workers would be left unemployed.

Still, the Fed views raising interest rates as the best method when it comes to fighting inflation. While elected leaders have a number of tools at their disposal to combat rising prices, like raising taxes to curb spending, such policies often take too much time to implement and are likely to be met with some resistance.

Since interest rate hikes go into effect immediately, economists say it has potential to more quickly help control inflation.

What impact will it have on consumers, investors, and businesses?

Rising interest rates can have a number of effects on market conditions and the economy, some of which are positive, and others that may carry some risks that are difficult to bear.

Interest rate hikes create tighter financial conditions during which credit spreads often fall, equity prices and stocks drop in value, and the strength of the U.S. dollar increases. Such financial conditions can hurt the economies of other countries, as their currencies may be weaker than the dollar. It can also put a strain on retirement savings and other investments if stock prices continue to fall, though Wall Street analysts say the stress shouldn’t last forever. The S&P 500 fell 0.5% after the Fed’s announcement on Wednesday.

Those with credit cards may also see rates rise due to the pinch of higher borrowing costs. Average credit card rates are currently at 18.7 percent, their highest level in 30 years, according to Bankrate.

Additionally, with mortgage rates more expensive, some Americans may find it more difficult to buy a house this winter even though the housing market is starting to ease up. The average rate for a 30-year fixed mortgage, the most popular home loan, was below 4% in late March but had topped 7% by late October, meaning some first-time home buyers who may not have enough money saved up could be pushed out of the market altogether.

But despite the risks, economists say the interest rate hikes are necessary to lower the burden on American households. Consumer prices in September were 0.4% higher than in August, and 8.2% higher than the year before. Some projections show that prices may continue to rise into next year.

Powell, the Fed chair, acknowledged that the path ahead could be difficult.

“It will take time, however, for the full effects of monetary restraint to be realized—especially on inflation,” Powell said on Wednesday. He added that “at some point” the Fed will slow the pace of rate increases.

Bright MLS Chief Economist Dr. Lisa Sturtevant said that consumers, businesses and investors should keep an eye on next Thursday’s Consumer Price Index, which tracks inflation, for signs of whether the Fed’s interest rate hikes have been working.

“If inflation remains stubbornly higher, the Federal Reserve will continue to aggressively raise rates,” she said in advance of the Fed’s meeting. “Under this scenario, mortgage rates could climb to 8% or beyond in late 2022 and into the first part of 2023.”

Fed officials have signaled that interest rates could be raised again in December and February before hitting a pause.