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Why a Federal Reserve interest rate hike could help to lower inflation

To combat rapidly rising prices across the country the central bank is trying to slow the economic growth and ease the pain for consumers.

Update:
Interest rate increase could help lowering prices
OLIVIER DOULIERYGetty

Earlier this week the Federal Reserve made a major play to combat the sky-high rate of inflation that is pushing up prices and causing headaches for consumers.

It was announced that the Fed would be raising benchmark interest rates three-quarters of a percentage point, the single most aggressive interest rate hike since 1994. This takes the level of the US central bank’s benchmark funds rate to a range of 1.5%-1.75%.

“Clearly, today’s 75 basis point increase is an unusually large one, and I do not expect moves of this size to be common,” said Fed Chair Jerome Powell after the news broke. He added that the Fed will “continue to communicate our intentions as clearly as we can.”

Fed tries to tame runaway inflation

President Biden has been clear that he wants the central bank to remain independent from the White House and has insisted that he is not putting pressure on the Fed to raise interest rates. However the Fed typically aims to keep inflation around the 2% mark annually – enough to ensure growth but not so much that prices increase out of step with wages.

The most effective tool the Fed wields in this regard is the ability to encourage or discourage borrowing, by raising or lowering interest rates. The theory is that when borrowing is expensive, consumer and business will be less likely to make fresh investments, cooling the demand in the market and hold down prices.

Raising interest rates also makes saving more profitable because a greater amount of interest will accrue on money that is not spent. It is hoped that this will also encourage people to save rather than spend, allowing the supply to catch up with demand and lower prices.

“The Fed uses interest rates as either a gas pedal or a brake on the economy when needed,” said BankRate’s chief financial analyst Greg McBride. “With inflation running high, they can raise interest rates and use that to pump the brakes on the economy in an effort to get inflation under control.”

What are the risks of raising the interest rate?

However, while adjusting interest rates can have a real impact on the economy it is a blunt tool and what that could bring with it some pretty undesirable results.

The US economy has made enormous progress in the past year as businesses were able to return to full operations after the vast majority of covid-19 restrictions were removed last year. The reopening of businesses and return to pre-pandemic condition is part of the reason for the current high rate of inflation, with fresh cash pouring into the market.

Raising interest rates and curbing spending does run the risk of undoing some of the economic progress made under Biden. Less consumer demand is likely to bring down prices but it could also discourage businesses from hiring new staff.

In short, excessive interest rate hike could slow economic growth to such an extent that the US actually slips into a recession, when the inflation rate drops below zero. The Federal Reserve will have to maintain a careful balance to stabilise the economy at the time when it remains vulnerable to changing circumstances.

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