How Raising Rates Control Inflation

If you follow the stock market and financial news, you have heard much talk about interest rates and inflation. It is a subject that is discussed in everyday circles.The Fed has raised rates to lower inflation.How does raising interest rates control inflation?Raising interest rates can send a shockwave throughout the whole economy. It can sink consumer confidence, fewer jobs, and lower stock prices.If the Fed goes too fast, it will send the economy into a recession.

So why would they even raise interest rates?Let’s start with the basics:If you borrow money, you will have to pay back a little extra (interest) to make it worthwhile for the bank to lend you the money.If you are taking out a loan, you want the lowest interest rate possible.If you save money, you will be given money (interest) as a reward for keeping money in the bank.The size of your reward depends on the state of the economy.There is no single interest rate in the economy. Thousands of commercial banks set their interest rates for their customers.Interest rates are influenced by the central bank, known as the Federal Reserve or the FED in the U.S.Central BanksWhat do central banks do? A central bank is like a bank for banks.Banks have reserves, which act as their cash on hand. Banks can earn interest when they leave their excess reserves with the central bank instead of lending money. This approach is very similar to how your savings account works for you.The average person doesn’t have access to the Federal Reserve rate, but it still affects them daily.

Why do central banks raise interest rates?When central banks raise interest rates, they try to control inflation, a.k.a. how fast prices rise for everyone.All central banks are trying to hit an annual inflation rate of 2%. This rate is a number that keeps assets growing, wages increasing, and the economy working how it should.Interest rates are a powerful tool to control this number.A rise in interest rates from a central bank means a commercial bank will earn more on its reserves.They will make more money by keeping it with the central bank than lending it out.If they do lend it out, they will raise their interest rates to make more.Mortgages are a prime example of how this helps/hurts the average person.If someone has a variable mortgage rate (popular in Finland/Australia), a high interest rate will hurt your monthly budget because you will lose cash each month.Less cash means less spending in the economy, causing the price of goods to decrease.In North America, fixed mortgages are a more popular option. These people will feel indirect pain from interest rate hikes. When mortgages are higher, the value of homes will come down, meaning people will lose their net worth.

 When interest rates rise, businesses will find it more expensive to borrow and invest. This action leads to less economic activity, jobs, and wages.Fewer jobs and lower wages will ultimately lead to less money for most households, causing consumer confidence to suffer.Less money will ultimately lead to households spending less, causing businesses to lower prices, aka sending inflation down.This viewpoint sounds straightforward, right?Unfortunately, the trick is figuring out how to raise interest rates.In 1981, inflation was at a record high, causing interest rates to rise 19%.The higher interest rate fixed the inflation problem but caused widespread economic pain.In 1981, we saw the worst economic mess since the great depression. It is only possible to control inflation by severely denting economic activity.In theory, inflation is okay. Raising interest rates can slow an economy right down.The problem is that it can take two years to see the full results of interest rate changes. Central banks know this and try to predict the future.