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How Do Higher Interest Rates Bring Down Inflation?
Our columnist is responding to readers’ questions. This week, he focuses on inflation, with the help of a bond maven and a Nobel laureate.
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Here's a look at inflation
The view that higher rates help stamp out inflation is essentially an article of faith, based on long-held economic gospel. But how does it really work?
SKIP NAVIGATION ECONOMY
Here’s how the Fed raising interest rates can help get inflation lower, and why it could fail
PUBLISHED FRI, APR 8 20221:52 PM EDTUPDATED SAT, APR 9 20221:17 AM EDT
Jeff Cox @JEFF.COX.7528 @JEFFCOXCNBCCOM WATCH LIVE KEY POINTS
Federal Reserve policymakers are going to try to slow down the economy and subdue inflation.
Higher rates make money costlier and borrowing less appealing. That, in turn, slows demand to catch up with supply, which has lagged badly throughout the pandemic.
Fed officials also have talked tough on inflation, in an effort to dampen future expectations.
Potential effects include lower wages, a halt or even a drop in home prices and a decline in stock market valuations.
A customer shops at at a grocery store on February 10, 2022 in Miami, Florida. The Labor Department announced that consumer prices jumped 7.5% last month compared with 12 months earlier, the steepest year-over-year increase since February 1982.
Joe Raedle | Getty Images
The view that higher interest rates help stamp out inflation is essentially an article of faith, based on long-held economic gospel of supply and demand.
But how does it really work? And will it work this time around, when bloated prices seem at least partially beyond the reach of conventional monetary policy?
It is this dilemma that has Wall Street confused and markets volatile.
In normal times, the Federal Reserve is seen as the cavalry coming into quell soaring prices. But this time, the central bank is going to need some help.
“Can the Fed bring down inflation on their own? I think the answer is ‘no,’” said Jim Baird, chief investment officer at Plante Moran Financial Advisors. “They certainly can help rein in the demand side by higher interest rates. But it’s not going to unload container ships, it’s not going to reopen production capacity in China, it’s not going to hire the long-haul truckers we need to get things across the country.”
Still, policymakers are going to try to slow down the economy and subdue inflation.
The approach is two-pronged: The central bank will raise benchmark short-term interest rates while also reducing the more than $8 trillion in bonds it has accumulated over the years to help keep money flowing through the economy.
Under the Fed blueprint, the transmission from those actions into lower inflation goes something like this:
The higher rates make money costlier and borrowing less appealing. That, in turn, slows demand to catch up with supply, which has lagged badly throughout the pandemic. Less demand means merchants will be under pressure to cut prices to lure people to buy their products.
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The Fed can’t escape the need for tough policies to combat inflation, says Komal Sri-Kumar
Potential effects include lower wages, a halt or even a drop in soaring home prices and, yes, a decline in valuations for a stock market that has thus far held up fairly well in the face of soaring inflation and the fallout from the war in Ukraine.
“The Fed has been reasonably successful in convincing markets that they have their eye on the ball, and long-term inflation expectations have been held in check,” Baird said. “As we look forward, that will continue to be the primary focus. It’s something that we’re watching very closely, to make sure that investors don’t lose faith in [the central bank’s] ability to keep a lid on long-term inflation.”
Consumer inflation rose at a 7.9% annual pace in February and probably surged at an even faster pace in March. Gasoline prices jumped 38% during the 12-month period, while food rose 7.9% and shelter costs were up 4.7%, according to the Labor Department.
The expectations game
There’s also a psychological factor in the equation: Inflation is thought to be something of a self-fulfilling prophecy. When the public thinks the cost of living will be higher, they adjust their behavior accordingly. Businesses boost the prices they charge and workers demand better wages. That rinse-and-repeat cycle can potentially drive inflation even higher.
That’s why Fed officials not only have approved their first rate hike in more than three years, but they also have talked tough on inflation, in an effort to dampen future expectations.
In that vein, Fed Governor Lael Brainard — long a proponent of lower rates — delivered a speech Tuesday that stunned markets when she said policy needs to get a lot tighter.
It’s a combination of these approaches — tangible moves on policy rates, plus “forward guidance” on where things are headed — that the Fed hopes will bring down inflation.
“They do need to slow growth,” said Mark Zandi, chief economist at Moody’s Analytics. “If they take a little bit of the steam out of the equity market and credit spreads widen and underwriting standards get a little tighter and housing-price growth slows, all those things will contribute to a slowing in the growth in demand. That’s a key part of what they’re trying to do here, trying to get financial conditions to tighten up a bit so that demand growth slows and the economy will moderate.”
Inflation 101: Why Does the Fed Care about Inflation?
We provide explanations of basic and fundamental concepts on the definition of inflation, measurement of inflation, costs of inflation, the importance of measuring and controlling inflation, the role of the Federal Reserve in inflation, and other concepts such as price indexes, hyperinflation, trend and underlying inflation, measures of inflation like CPI, core CPI, median CPI, trimmed-mean CPI, PCE, core PCE, and trimmed-mean PCE.
Why Does the Fed Care about Inflation?
Get started Get technical
Some countries have experienced such high inflation rates that their money became worthless. Imagine going to the store with boxes full of money and not being able to buy anything with it because prices have gotten so high! At such high inflation rates, the economy tends to break down.
The Federal Reserve, like other central banks, was established to foster economic prosperity and social welfare. Part of the mission given to the Federal Reserve by Congress is to keep prices stable–that is, to keep prices from rising or falling too quickly. The Federal Reserve sees a rate of inflation of 2 percent per year–as measured by a particular price index, called the price index for personal consumption expenditures–as the right amount of inflation.
The Federal Reserve seeks to control inflation by influencing interest rates. When inflation is too high, the Federal Reserve typically raises interest rates to slow the economy and bring inflation down. When inflation is too low, the Federal Reserve typically lowers interest rates to stimulate the economy and move inflation higher.
Inflation Is Just One of the Fed's Jobs
Watch to find out about all the Federal Reserve's responsibilities and why it needs to keep inflation under control. 9 minutes
Want to keep reading? Learn the basics of inflation
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