The Rise of Interest Rates
By Anriya Wang and Neil Tamhankar
The Federal Reserve (which is the central bank of the United States) recently announced that they will be raising interest rates multiple times throughout this year in an effort to tamp down the rampant inflation the United States is currently experiencing. Before we can talk about interest rates, however, we need to understand how we got here. Inflation is an economic phenomena in which prices for most goods/services rapidly rise, decreasing the spending power of consumers.
The inflation crisis is the culmination of a few factors, from massive government spending at the beginning of the pandemic in March 2020 to global supply chain issues to extremely high consumer demand when the economy started opening back up last year. It’s become a big problem, with nearly everything being more expensive than Americans are used to. But how do interest rates combat inflation?
First, you have to know what interest rates are. At their core, interest rates are the costs of borrowing money. The most common use you will see is that they determine how much interest people have to pay when they take loans from the bank. For example, if Bob borrows $1000 from the bank at a 5% interest rate, the 5% (or $50) is the cost of borrowing that money. He will have to pay the bank $1,050 back. In terms of fighting inflation, the concept is fairly simple. With higher interest rates, people are less happy with borrowing money from the bank, therefore not borrowing as much. People then have less money with which to spend. Decreased spending in an economy cools down inflation, which is the goal of the Fed. Consumers like Bob aren't the only ones who borrow money. Business owners often take loans to invest in their business (think: a moving company borrowing $30,000 from Wells Fargo to buy a van). Don’t confuse business investment with securities investment, though. Investing in securities is purchasing abstract contracts of ownership, while business investment is purchasing capital that produces actual goods. Raising interest rates means people have less spending money and are not investing in their businesses as much, slowing economic growth. Generally, you may think slowing economic growth is a bad thing, but when faced with rapid inflation, it's the golden scenario.
The Fed has a couple methods of raising interest rates. The first has to do with the federal funds rate. The federal funds rate is the interest rate at which banks borrow money from each other. Raising the federal funds rate makes it harder for banks to borrow money from each other, which indirectly slows down the economy. For example, if the federal funds rate was at 5%, then banks have to pay a 5% interest rate when borrowing money from each other. If the Fed raised that rate to 10%, less banks would borrow money from each other since the cost is higher. Therefore, banks will have less money on reserves, so there would be less money in circulation. Less money in circulation = less inflation.
The Fed can also raise the discount rate, which is the rate that banks pay to borrow money from the Fed. This essentially increases costs for banks borrowing from the Fed, who then have to raise their interest rates for consumers to maintain a profit. Higher interest rates for consumers will lead to less inflation.
The final, most common way the Fed raises interest rates is by executing open market operations. Open market operations are the Fed buying/selling securities. For regulating interest rates, the Fed usually buys/sells bonds to banks (for raising interest rates, they will sell bonds). When the Fed sells bonds, the banks give the Fed money in exchange for the bonds. The exchange of money for bonds decreases the total money supply in the economy, because the Fed holds on to the money instead of letting it flow freely in the economy. This is effective because bonds are very illiquid, meaning that they are not easily converted back into cash. When there is less money, the price of money (interest rates) rises, which decreases inflation. Now that you know the basics, let’s look at the specifics of the Fed’s announcement.
Fed Chairman Jerome Powell announced plans to raise interest rates at their March 15-16 meeting this year, the first increase in over three years. The interest rate hikes aim to counter the surging levels of inflation. As the worst effects of Covid-19 pass, unemployment rates are dropping, and consumer prices are skyrocketing. Inflation is at its highest in nearly forty years.
Because of this, the Fed plans to hike rates four times this year, at a rate of 0.25% each time. However, they are open to both gradual or aggressive approaches as inflation rates can suddenly change — the frequency and percentage of increases will change if necessary.
Economists at Bank of America Global Research predict seven 0.25% interest rate hikes, one at each Fed meeting for the rest of the year. That will raise the total interest rate to between 2.75% and 3% by the end of 2022. Although these inflation rates must shrink quickly, the process must be done carefully. Dramatic price shifts can harm the economy — it forces employers to not only hire fewer people but also take fewer business loans. Unexpected inflation changes may also throw plans off course. For instance, worsened supply chain issues might increase inflation and force the Fed to implement more aggressive changes.
As interest rates grow closer to normal, around 1% or 1.25%, the Fed plans to moderate how many bonds they buy. They bought many to stabilize markets and the economy during the pandemic, but that is no longer needed. The Fed now looks to shrink its bond holdings and reduce its balance sheet.
To sum up: In order to combat the inflation crisis our nation is enduring, the Fed will raise interest rates by raising the federal funds rate (interest rate at which banks borrow money from each other), raising the discount rate (rate at which banks borrow money from the Fed), or by selling bonds to banks (which decreases the supply of money, increasing interest rates). If all goes according to plan, and the interest rate hikes cool inflation, we could be back in a normal economy as early as one year from now.
