Inflation 101: How Does Raising Interest Rates Help Inflation?
The Fed raises interest rates amid high inflation, but what good does that do?
Contributing Writer at Tally
December 6, 2022
When inflation hits, the Federal Reserve — sometimes referred to as the Fed or the central bank of the U.S. — jumps into action to help reduce prices. It does this through incremental increases in the federal funds rate, which is the interest rate banks charge each other to borrow or lend excess reserves overnight.
But how does raising interest rates help inflation? We’ll explore that and more, but first, let’s dig into what inflation is and what causes it.
What is inflation?
Inflation is a rise in the overall prices of the goods and services we buy. While prices are constantly fluctuating, inflation is when those price increases result in lower purchasing power. Generally, you’ll see inflation expressed as a percentage.
For example, if a dozen eggs cost $1.50 this time last year and $1.55 this year, that’s a 5-cent price increase. That price increase is represented as a 3.33 percent rate of inflation (0.05 / 1.25 = 0.0333 or 3.33 percent). This is a very simplified version of inflation, as it generally considers all goods and services, not just one particular item.
Deflation is the exact opposite. That’s when prices decrease and our spending power increases.
Small pockets of inflation or deflation often have little impact on our overall financial lives. However, when inflation or deflation is consistent, it can significantly impact our finances, particularly our debt.
The Fed determines inflation by looking at the consumer price index (CPI) from 12 months ago and comparing it to the CPI in the same period in the current year. The CPI is a measure of the average price changes of consumer goods and services over time.
What causes inflation?
Inflation has two common root causes: production cost and demand.
Demand-pull inflation is when there are too many people with too much cash trying to purchase too few goods, throwing off the balance of supply and demand. If we’re suddenly flush with cash, we tend to spend more, which drives demand upward and thins out the supply of available goods.
Once demand starts to rise and supplies fall, prices will creep upward. A good example of how these higher prices appear can be found in the new car market. If a special edition vehicle comes out or a particular vehicle is in extremely high demand, dealerships will often add a dealer markup on top of the manufacturer’s suggested retail price because people who want the car are willing to pay a higher price.
The other kind of inflation is cost-pull inflation. This is when the cost to produce an item rises due to supply chain shortages, higher raw material prices or a rise in wages. Demand will remain steady, but the manufacturer is forced to raise prices to compensate for the additional cost of producing the item.
For example, if the price of steel suddenly rises, car manufacturers could raise prices to make up for the increased cost.
How does raising interest rates help inflation?
The Federal Reserve is responsible for promoting maximum employment and stable prices and currently says a 2 percent annual inflation rate is considered stable pricing; anything above that’s regarded as unstable. So it creates monetary policy to maintain that roughly 2 percent inflation.
When there’s demand-pull inflation, the Fed generally uses interest rates to help fight inflation. The Fed’s goals are to slow consumer demand, consumer spending and bring prices back down. They do this by increasing the federal funds rate by a fraction of a percentage point at a time. This will gradually increase interest rates.
As interest rates rise, consumers tend to purchase fewer large-ticket items like cars, real estate and pricey electronics due to the higher cost of borrowing. This then lowers demand, calming a surging inflation rate.
For example, as of October 2022, the Fed has enacted several interest rate hikes, bringing the federal funds rate from 0.25 percent to 3.25 percent, due to the highest inflation the U.S. has seen in 40 years.
How do rising interest rates affect debt?
Because the federal funds rate affects all consumer interest rates, it also impacts debt. Let’s explore how higher interest rates due to high inflation impact various types of debts.
Credit cards and lines of credit
Credit cards and lines of credit are some of the first kinds of debt to feel the pinch of a rising Federal Reserve rate. Credit cards and lenders that offer lines of credit generally base their variable prime rate — the interest rate they charge customers with top-tier interest rates — on the federal funds rate.
So, you’ll likely see your credit card interest rate rise when the Fed rate increases. This means higher interest charges on your statement every month, given that your credit card likely has a variable interest rate.
If you’ve got an adjustable-rate mortgage (ARM), which has a variable interest rate, you may also feel the pressure. These loans are also based on the federal funds rate, so as that rate rises, your variable interest rate also will go up during its adjustment periods — the preset periods when the lender can adjust your mortgage interest rate.
The rising mortgage rate will result in higher monthly payments.
While they’re not overly common, some lenders offer variable-rate auto loans. Like ARMs above, a variable-rate auto loan’s interest rate will rise and fall along with the federal funds rate.
As the central bank raises the federal funds rate, the interest rate on your variable-rate auto loan would also increase, resulting in a higher monthly payment.
Personal loans, like mortgages and auto loans, can have variable interest rates. This means that, like the loans mentioned earlier, a personal loan’s interest rate increases if the Fed raises the federal funds rate.
This can result in higher monthly payments and more interest paid.
Can you offset inflation-based interest rate hikes somehow?
Improved consumer spending and consumer confidence are good things, to a point. However, once this leads to demand-pull inflation, things can get bad for consumers: As the Fed raises interest rates, it results in higher interest on consumer debt. So can you offset some of the interest rate hikes on debt during inflation?
Yes, you can. These interest rate hikes don’t only affect consumer debt. They can also affect the annual percentage yield (APY) — the interest you earn — on savings and investments. For example, if your high-yield savings account earns 1.5 percent APY, the bank may raise it to 1.75 percent APY if the Fed raises its rate. This means your savings account is growing at a faster rate.
You can also invest in other financial products that generally give higher returns when the Fed increases the federal funds rate, such as:
Can rising interest rates hurt the US economy?
You now know the answer to “How does raising interest rates help inflation?” but there are other, negative things raising interest rates can do.
Higher interest rates mean reduced consumer confidence, leading to dramatically reduced spending in many cases, and may halt all economic growth. This slowdown in economic activity can result in a full-on economic recession, which can lead to job losses, possibly creating high unemployment rates and a tumbling stock market.
Higher interest rates can also target specific consumer markets, such as housing and vehicles. Consumers often must lower their discretionary spending budgets as the rates go up on car loans and home mortgages. Some may stop shopping for a car or home altogether, leading to dramatically less revenue and profit for these industries.
Rising interest rates can stave off inflation
As mentioned before, raising interest rates helps inflation by reducing consumer borrowing and spending, thereby cooling off demand for goods and services. This then helps lower prices and reduce inflation. Yet, this can be troubling because it leads to higher interest rates on loans. However, the higher interest rates may also impact some interest-bearing investments and accounts, allowing consumers to earn more interest from them.
If you have credit card debt with interest rates that continue going up, the Tally† credit card debt repayment app can help. Our app helps you manage your credit card payments and also offers a lower-interest personal line of credit, allowing you to efficiently pay off higher-interest credit cards.
†To get the benefits of a Tally line of credit, you must qualify for and accept a Tally line of credit. The APR (which is the same as your interest rate) will be between 7.90% and 29.99% per year and will be based on your credit history. The APR will vary with the market based on the Prime Rate. Annual fees range from $0 to $300.