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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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    How raising interest rates curbs inflation – and what could possibly go wrong

    Higher interest rates reduce demand for goods and services, which makes it harder for companies to raise prices. But there are risks as well.

    Rodney Ramcharan, University of Southern California

    After about three decades of relatively low inflation, consumer prices are skyrocketing again.

    The price of gasoline, for example, was up 40% in January 2022 from a year earlier, while used cars and trucks jumped 41%, according to data released on Feb. 10, 2022. Other categories experiencing high inflation include hotels, eggs, and fats and oils, up 24%, 13% and 11%, respectively. On average, prices climbed about 7.5%, the fastest pace of inflation since 1982.

    It’s part of the mandated job of the U.S. Federal Reserve to prevent inflation from getting out of hand – and lowering it back to its preferred pace of about 2%.

    To do that, the Fed has signaled it plans to raise interest rates several times this year – perhaps as many as five – beginning in March. And January’s faster-than-expected inflation figures suggest it may have to accelerate its overall timetable.

    Will this work? If so, why?

    I’m an economist who has been studying how monetary policy affects the economy for decades while working at the Federal Reserve, the International Monetary Fund and now the University of Southern California. I believe the answer to the first question is most likely yes – but it will come at a cost. Let me explain why.

    Higher rates reduce demand

    The Federal Reserve controls the federal funds rate, often referred to as its target rate.

    This is the interest rate that banks use to make overnight loans to each other. Banks borrow money – sometimes from each other – to make loans to consumers and businesses. So when the Fed raises its target rate, it raises the cost of borrowing for banks that need funds to lend out or meet their regulatory requirements.

    Banks naturally pass on these higher costs to consumers and businesses. This means that if the Fed raises its federal funds rate by 25 basis points, or 0.25 percentage point, consumers and businesses will also have to pay more to borrow money – just how much more depends on many factors, including the maturity of the loan and how much profit the bank wants to make.

    This higher cost of borrowing in turn dampens demand and economic activity. For example, if a car loan becomes more expensive, maybe you’ll decide now is not the right time to buy that new convertible or pickup truck you had your eye on. Or perhaps a business will become less likely to invest in a new factory – and hire additional workers – if the interest it would pay on a loan to finance it goes up.

    This is the cost to the economy when the Fed raises interest rates.

    And reduced demand lowers inflation

    At the same time, this is exactly what slows the pace of inflation. Prices for goods and services typically go up when demand for them rises. But when it becomes more expensive to borrow, there’s less demand for goods and services throughout the economy. Prices may not necessarily go down, but their rate of inflation will usually decline.

    To see an example of how this works, consider a used car dealership, where the pace of inflation has been exceptionally high throughout the pandemic. Let’s assume for the moment that the dealer has a fixed inventory of 100 cars on its lot. If the overall cost of buying one of those cars goes up – because the interest rate on the loan needed to finance one rises – then demand will drop as fewer consumers show up on the lot. In order to sell more cars, the dealer will likely have to cut prices to entice buyers.

    In addition, the dealer faces higher borrowing costs, not to mention tighter profit margins after reducing prices, which means perhaps it couldn’t afford to hire all the workers it had planned to, or even has to lay off some employees. As a result, fewer people may be able to even afford the down payment, further reducing demand for cars.

    Now imagine it’s not just one dealer seeing a drop in demand but an entire US$24 trillion economy. Even small increases in interest rates can have ripple effects that significantly slow down economic activity, limiting the ability of companies to raise prices.

    The risks of raising rates too quickly

    But our example assumes a fixed supply. As we’ve seen, the global economy has been dealing with massive supply chain disruptions and shortages. And these problems have driven up production costs in other parts of the world.

    If high U.S. inflation stems mainly from these higher production costs and low inventories, then the Fed might have to raise interest rates by a great deal to contain inflation. And the higher and faster the Fed has to raise rates, the more harmful it will be to the economy.

    In keeping with our car example, if the price of computer chips – a critical input in cars these days – is increasing sharply primarily because of new pandemic-related lockdowns in Asia, then carmakers will have to pass on these higher prices to consumers in the form of higher car prices, regardless of interest rates.

    In this case, the Fed might then have to dramatically raise interest rates and reduce demand substantially to slow the pace of inflation. At this point, no one really knows how high interest rates might need to climb in order to get inflation back down to around 2%.

    Updated to note impact of January inflation figures on Fed.

    [You’re smart and curious about the world. So are The Conversation’s authors and editors. You can read us daily by subscribing to our newsletter.]

    Source : theconversation.com

    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?


    Here’s how the Fed raising interest rates can help get inflation lower, and why it could fail



    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.


    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.”

    Source : www.cnbc.com

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