How will increases in interest rates affect inflation?

The Federal Reserve is expected to announce its fourth interest rate hike of 2022 on Wednesday as it scrambles to contain rapid inflation. The moves have many people wondering why rate hikes, which raise the cost of borrowing money, are America’s main tool for cooling prices.

Sen. Elizabeth Warren, a Democrat from Massachusetts, wrote an opinion piece in The Wall Street Journal on Sunday arguing that the Fed’s rate hikes to squelch demand are not the right policy to combat current inflation, as the costs of the Fuel and supply chain turmoil push prices up. The policies will hurt workers, she said, and “it doesn’t have to be that way.”

Others have argued that the Fed should remain forceful. Lawrence H. Summers, the former Democratic treasury secretary, argued during an interview on CNN this week that the Fed needed to take “strong action” to rein in inflation and that allowing inflation to run amok would be the “biggest mistake” to make. a recession

Viewers could be excused for struggling to make sense of the debate. Fed officials themselves acknowledge that their tools are blunt, that they cannot fix broken supply chains, and that it will be difficult to slow the economy enough without causing an economic downturn. So why is the Fed doing this?

The US central bank has for decades been what Paul Volcker, its chairman in the 1980s, called “the only game in town” when it comes to fighting inflation. While there are things elected leaders can do to combat rising prices (raise taxes to curb consumption, spend more on education and infrastructure to improve productivity, help ailing industries), those specific policies tend to take time. The things that elected politicians can do quickly usually help mostly on the edges.

But time is of the essence when it comes to controlling inflation. If price increases are rapid over months or years, people begin to adjust their lives accordingly. Workers could ask for higher wages, driving up labor costs and causing companies to charge more. Companies may begin to believe that consumers will accept price increases, making them less likely to avoid them.

By making money more expensive to borrow, the Fed rate moves labor relatively quickly to temper demand. As buying a house or a car or expanding a business becomes more expensive, people turn away from doing those things. With fewer consumers and businesses competing for the available supply of goods and services, price gains may moderate.

Unfortunately, that process could come at a high cost at a time like this. Balancing the economy when supply is tight — cars are hard to find because of semiconductor shortages, furniture is behind schedule, and jobs are more plentiful than workers — could require a big drop in demand. A slowdown in the economy that could significantly trigger a recession, leaving workers unemployed and families with lower incomes.

Economists at Goldman Sachs, for example, estimate the probability of a recession in the next two years to be 50 percent. Already signs abound that the economy is slowing as the Fed begins to raise rates, with headline growth data, housing market trackers and some consumer spending metrics showing a pullback.

But central bankers believe that even if the risks are difficult to take, they are necessary. Sure, a recession that increases unemployment would be painful, but inflation is also a major handicap for many families today. Getting it under control is critical to putting the economy back on a sustainable path, officials argue.

“It is essential that we bring inflation down if we are to have a sustained period of strong labor market conditions that benefit everyone,” Fed Chairman Jerome H. Powell said at his news conference last month.

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