The Federal Reserve’s war on inflation: How it works
By keeping borrowing costs high, the Fed is hoping to cool the economy.
The battle to lower inflation continues. Halfway through 2024, and the Federal Reserve’s key interest rate is still at 5.25%-5.5%, the highest in two decades. While some experts expect rates
cuts by three-quarters of a percentage point by the end of the year, leaders of the U.S. central bank suggest interest rates may remain at the higher levels. By keeping borrowing costs high, the Fed is hoping to cool the economy. (Download full page pdf.)
HOW INTEREST RATES REGULATE INFLATIONThe Federal Reserve board is responsible for setting the target for the Federal Funds Rate — a banking industry interest rate. To counter inflation, the Fed can increase this rate in an attempt to shrink the supply of money available to make purchases. And to stimulate economic growth, it can lower the interest rate, giving people more money to spend.
WHAT HIGHER INTEREST RATES DO
1. Money is expensive: By raising rates, the Fed hopes costlier financing will temper demand for consumer goods and services.
2. Less spending: With higher interest rates, banks make fewer loans. Less disposable income means that consumers must cut back on spending and save more.
3. Employment drops: As businesses cut spending, the number of employees can decrease as well. Businesses will also need more cash flow to cover inflated interest costs.
4. Stocks can fall: Higher interest rates often translate to a drop in the stock markets. Increased financing costs can cut into the bottom line of businesses and corporations. Investors will typically sell off their stocks to protect profits, moving them into bonds.
WHAT LOWER INTEREST RATES DO
1. Money is cheap: By cutting rates, the Fed hopes cheaper financing stimulates demand for consumer goods and services.
2. Consumer spending is up: Cheap money encourages consumers and businesses to borrow, spend and invest more. That can boost prices based on supply and demand.
3. Productivity increases: An economic bonus is that large investments by businesses can boost productivity.
4. Jobs are up: The increased demand for consumption and investment can lead to higher demand for labor.
HOW HIGH INTEREST RATES AFFECT …
Savers are obvious winners as they enjoy higher returns on the low-risk investments. Bondholders may like higher yields, but the value of old bonds can suffer as rates rise on new bond offerings. Stocks have an odd relationship with interest rates. When rates rise due to a strong economy, share prices can rise. But shares can also dip as higher yields on competing, lower-risk assets look more attractive.
Typically, lower interest rates stimulate the housing market. House hunters often flock to buy with cheap money. The flood in demand usually pushes prices higher. Conversely, higher rates can trim demand and prices as fewer house hunters can qualify for a mortgage. The current housing market is an exception. While interest rates soar, current homeowners with historically low 30-year fixed mortgages are not selling. That’s meant an abnormally low inventory of homes on the market. Despite fewer qualified buyers, demand still boosts home prices.
SOURCES: Rocket Mortgage, Investopedia, USA TODAY, Axios, Forbes, MSNBC, CNBC, thebalanceomoney.com, The Atlanticcom, CNN Business, The Atlantic, Bloomberg, Yahoo Finance, The New York Times