In response to high inflation, the Federal Reserve voted earlier this week to raise the federal funds rate by 0.5 percentage points, the . When the Fed raised rates in March, it projected there would be as many as six rate hikes throughout the year.
“Inflation is much too high and we understand the hardship it is causing, and we’re moving expeditiously to bring it back down,” said Jerome Powell, the chair of the Federal Reserve, in a press conference on Wednesday (PDF). “We have both the tools we need and the resolve it will take to restore price stability on behalf of American families and businesses.”
This move comes on the heels of a record-high inflation rate, which increased 8.5% over the last year, according to the Consumer Price Index, rising by 0.6% through March. Consumer prices increased by 1.2% since February, with accounting for over half of the monthly increase.
Raising interest rates is a key step to combatting rampant inflation, which is at a 40-year high, and will jump-start the process ofmortgages and other loans. And although raising rates is designed to curb inflation, Powell acknowledged that he still expects inflation to run high through the rest of this year.
With rates rising and more increases on the way, what’s next? I’ll walk you through how this happened, what the Fed is doing about it and what rising interest rates mean for you.
High inflation means your dollar has less purchasing power, making everything you buy more expensive even though you’re likely not getting paid more. In fact, more Americans are living paycheck to paycheck, and wages are not keeping up with inflation rates.
Inflation surged in March, increasing 8.5% over the past 12 months and reaching its highest level since December 1981, according to the Bureau of Labor Statistics. also reached their highest recorded average of $4.31 per gallon last month, with grocery prices following suit, hitting their highest increase since April 2020.
Though the immediate impacts of COVID-19 on the US economy are easing up, the supply and demand imbalances persist, one of the main contributors to swelling prices.— which threatens political and economic stability worldwide — is another key driver of skyrocketing gas prices. The cost of fuel has been so volatile that it accounted for nearly one-third of February’s overall price increases.
We’re here because of the pandemic.
In March 2020, the onset of COVID-19 caused the US economy to shut down. Millions of employees were laid off, many businesses had to close their doors and the global supply chain was abruptly put on pause. This caused the flow of goods shipped into the US to cease for at least two weeks, and in many cases, for months, according to Pete Earle, an economist at the American Institute for Economic Research.
But the reduction in supply was met with increased demand as Americans started purchasing durable goods to replace the services they used prior to the pandemic, said Josh Bivens, director of research at the Economic Policy Institute.
“The pandemic put distortions on both the demand and supply side of the US economy,” Bivens said. “On the demand side, it channeled tons of spending into the narrow channel of durable goods. And then, of course, that’s the sector that needs a healthy supply chain in order to deliver goods without inflationary pressures. We haven’t had a healthy supply chain overwhelmingly because of COVID.”
This increased demand combined with the supply chain kinks induced inflation, which has persisted since the 2021 reopening of the economy.
That noted, inflation isn’t inherently a good or bad thing. Moderate and steady inflation is actually important for a healthy economy: It promotes spending since rising prices encourage consumers to buy now, rather than later, keeping demand up. Inflation can become a problem when it rises over 2% (as measured by the Fed) and when it rises rapidly. That messes with healthy consumer spending and, in extreme cases, can derail price stability.
With inflation hitting record highs, the Federal Reserve, the government body in charge of keeping inflation in check, has been under a great deal of pressure from policymakers and consumers to get the situation under control. One of the Fed’s primary tenets is to promote price stability and maintain inflation at a rate of 2%. To counteract inflation’s rampant growth, the Fed raised the federal funds rate by half of a percentage point this week.
The federal funds rate is the interest rate that banks charge each other for borrowing and lending, usually on an overnight basis. By raising this rate, the Fed effectively drives up interest rates in the US economy.
Raising interest rates helps slow down the economy by making borrowing more expensive. In turn, consumers, investors and businesses pause on making investments, which leads to reduced economic demand and theoretically reels in prices. In short, this helps balance the supply and demand scales, one cause of inflation that was thrown out of whack by the pandemic.
The Fed, which calculates inflation differently than the CPI, estimated inflation was at 6.4% as of February. The typical Federal Open Market Committee member — the Fed’s policy-making body — projects this number could decrease to 4.3% (PDF) by the end of the year, following a series of rate hikes.
Raising interest rates will make it more expensive for both businesses and consumers to take on loans. For the average consumer, that means buying a car or a, since you’ll pay more in interest.
For the past two years, interest rates have been at historic lows, partially because the Fed slashed interest rates in 2020 to keep the US economy afloat in the face of lockdowns. Since then, the Fed has kept interest rates near zero, a move made only once before, during the financial crisis of 2008. Prior to the Fed’s recent rate hike, interest rates had already started rising in 2022. For example, 30-year fixed mortgage rates, while still historically low, are returning to pre-pandemic levels.
Increasing rates could make it more difficult toor at lower interest rates. Moreover, the Fed’s move will also drive up interest rates on , ratcheting up minimum payments along with it.
While inflation is top of mind for many Americans, experts don’t think hyperinflation is a concern right now.
The Fed took initial steps to counteract inflation by reducing its bond-buying program by $15 billion monthly in November last year, a rate which was increased to $30 billion in order to accommodate potentially raising interest rates sooner than planned — which is exactly what the Fed did in March and earlier this week.
And though this rate hike is expected to help bring down inflation, there’s still a concern on the table, as another five rate hikes are expected this year. If the Fed overreacts by raising rates too high, it could spark an economic downturn, or worse, induce a recession.
Raising rates too quickly may hinder consumer demand too greatly and unduly stifle economic growth, potentially leading businesses to lay off workers or stop hiring. This could drive up unemployment, which would lead to another problem for the Fed, as it is also tasked with boosting employment.
But with inflation persisting and threatening to become entrenched in the US economy, Powell acknowledged that the Fed will raise interest rates more aggressively if needed. “The Committee is determined to take the measures necessary to restore price stability,” Powell said this week (PDF). “The American economy is very strong and well positioned to handle tighter monetary policy.”
We’ll keep you updated on the evolving economic situation as the Fed moves forward with more rate hikes this year.