The Federal Reserve signalled plans to begin raising interest rates “soon” in a bid to tamp down inflation before it poses a serious risk to the US economy. A hike would be the first time the American central bank has increased its benchmark lending rate in over three years.
Lifting the borrowing costs consumers and businesses pay for loans have the effect of slowing economic activity, which in turn could curb inflation. But there are also concerns that it could put on the brakes too quickly. We asked Alexander Kurov, a finance professor at West Virginia University, and Marketa Wolfe, an economist at Skidmore College, to explain what the Federal Reserve is doing and what it means for you.
1. Why is the Federal Reserve raising interest rates?
Short-term interest rates in the United States are now essentially zero.
The Federal Reserve quickly cut rates to zero at the beginning of the Covid-19 crisis in March 2020 in an attempt to soften the blow of the sharp recession that began that month as the US went into lockdown. As a reminder of how bad things were back then, over 40 million workers – a quarter of the American workforce – filed for unemployment in the first few months of the pandemic, a staggering number with no precedent in the job market.
Although the recession was short-lived – lasting only two months – and the economy has mostly recovered, the Federal Reserve has kept rates at rock bottom because many workers and businesses still need support as the pandemic continues to rage.
The big problem for the Federal Reserve now is that US consumer prices have surged. For 10 months in a row, inflation has been above the Federal Reserve’s 2% target and reached an annual pace of about 7% in December. This is the highest rate of inflation recorded in the US in the last 40 years. High inflation means the prices people pay for goods and services are continually going up – especially for basic items like meat and gasoline, as well as for manufactured goods like cars.
The Federal Reserve can ill afford to allow this to continue because if higher inflation becomes entrenched, it would damage the economy. And the longer it lasts, the harder – and more painful for consumers and businesses – it is going to be to bring it back to a more sustainable 2%.
So the Federal Reserve has to act quickly before it is too late.
2. How does the Federal Reserve raise rates?
The Federal Reserve sets a target range for what is called the “federal funds rate”. This rate acts as a benchmark for all interest rates in the economy.
While the Federal Reserve did not specify a time when it plans to raise rates, analysts expect the first increase to come in March, probably by 0.25 percentage point. This would affect banks’ cost of borrowing, which in turn slowly filters throughout the economy as lenders charge more for loans on homes, cars, businesses, college tuition and anything else you might want to buy with debt. Banks would also gradually increase the interest they offer on deposits and savings accounts.
The Federal Reserve does not directly control all these other rates, and the exact path they will take is not completely predictable, but the overall trend will be up if the central bank keeps raising its target rate.
Markets expect the Federal Reserve to raise interest rates at least two more times in 2022.
3. What does that mean for consumers and businesses?
Put simply, higher interest rates mean borrowers would need to pay more for the loans they get.
If the Federal Reserve lifts interest rates this year by 0.75 percentage point, as expected, this would translate into about $45,000 in additional interest payments on a 30-year, $300,000 mortgage.
So if you want to borrow to start a business, pay for college, buy a car or do anything else, you should expect your borrowing costs to be higher later this year.
On the other hand, higher rates is good news for savers and investors, as their returns from activities like making deposits and buying bonds will go up.
4. And how will it affect the broader economy?
Higher interest rates would likely slow down business activity. While this can help reduce inflation, it also means lower economic growth.
The Federal Reserve always makes decisions based on what is happening in the economy and on how economic conditions are expected to change. And changes in the economy are often hard to predict.
The biggest unknown at this point is what will happen to inflation later this year. This is uncertain because inflation is driven by multiple factors, such as supply chain shortages and strong demand.
In addition, the labor force participation rate has still not recovered to pre-pandemic levels, and the economy is experiencing labour shortages, which could push wages and prices higher. If these Covid-19-related pressures do not ease up soon, inflation could continue to stay high or continue to accelerate, which may force the Federal Reserve to increase interest rates faster than currently expected.
On the other hand, if economic or employment growth stalls, this will make it much harder for the Federal Reserve to raise rates without making things worse. The Federal Reserve will need to find the right balance between taming inflation and avoiding slowing down the economy too much.
Alexander Kurov is Professor of Finance and Fred T Tattersall Research Chair in Finance at the West Virginia University. Marketa Wolfe is Associate Professor of Economics at the Skidmore College.
This article first appeared on The Conversation.