After about three decades of relatively low inflation, consumer prices are soaring again.

The price of gasoline, for example, rose 40% in January 2022 from a year earlier, while used cars and trucks jumped 41%, according to data released on February 10, 2022. Other categories experiencing high inflation include hotels, eggs, and fats and oils, up 24%, 13%, and 11%, respectively. On average, prices rose about 7.5%, the fastest rate of inflation since 1982.

It’s part of the US Federal Reserve’s mandate to keep inflation from spiraling out of control and bring it back to its preferred rate of around 2%.

To do this, the Fed has announced its intention to raise interest rates several times this year – possibly as many as five times – starting in March.

Will it work? If yes, why?

I am an economist who has studied the impact of monetary policy on the economy for decades while working at the Federal Reserve, the International Monetary Fund, and now at the University of Southern California. I believe the answer to the first question is most likely yes – but it will come at a cost. Let me explain why.

Higher rates reduce demand

The Federal Reserve controls the federal funds rate, often referred to as its target rate.

This is the interest rate banks use to lend each other overnight. Banks borrow money – sometimes from each other – to make loans to consumers and businesses. So when the Fed raises its target rate, it increases the cost of borrowing for banks that need funds to lend or meet their regulatory requirements.

Banks naturally pass on these higher costs to consumers and businesses. This means that if the Fed increases its federal funds rate by 25 basis points, or 0.25 percentage points, consumers and businesses will also have to pay more to borrow money – how much more depends on many factors, including understood the maturity of the loan and what profit the bank wants to make.

This higher cost of borrowing in turn dampens demand and economic activity. For example, if a car loan gets more expensive, you might decide that now is not the right time to buy that new convertible or pickup truck you’ve been eyeing. Or perhaps a company will become less likely to invest in a new factory – and hire additional workers – if the interest it would pay on a loan to finance it increases.

This is the cost to the economy when the Fed raises interest rates.

And falling demand lowers inflation

At the same time, this is exactly what slows down the rate of inflation. The prices of goods and services generally increase when demand increases. But when it becomes more expensive to borrow, demand for goods and services decreases across the economy. Prices will not necessarily go down, but their inflation rate will generally go down.

To see an example of how this works, consider a used car dealership, where the pace of inflation has been exceptionally high throughout the pandemic. Assume for the moment that the dealer has a fixed inventory of 100 cars on his lot. If the overall cost of buying one of these cars goes up – because the interest rate on the loan needed to finance one goes up – demand will fall as fewer consumers show up in the field. In order to sell more cars, the dealership will likely have to lower prices to attract buyers.

Additionally, the dealer faces higher borrowing costs, not to mention tighter profit margins after the price cut, which means they may not be able to afford to hire all the workers. he had planned, or even that he has to lay off some employees. As a result, fewer people might be able to afford even the down payment, further reducing the demand for cars.

Now imagine that it’s not just a dealership that sees a drop in demand, but an entire $24 trillion saving. Even small increases in interest rates can have ripple effects that significantly slow economic activity, limiting companies’ ability to raise prices.

The risks of rising interest rates too quickly

But our example assumes a fixed supply. As we have seen, the global economy has faced massive supply chain disruptions and shortages. And these problems have driven up production costs in other parts of the world.

If high inflation in the United States stems primarily from these higher production costs and low inventories, the Fed may need to raise interest rates significantly to contain inflation. And the faster the Fed has to raise rates high and fast, the more damaging it will be to the economy.

Consistent with our automotive example, if the price of computer chips – a key input in cars these days – rises sharply primarily due to the new pandemic-related lockdowns in Asia, automakers will need to pass these higher prices on to consumers. in the form of rising car prices, regardless of interest rates.

In this case, the Fed may then have to raise interest rates significantly and reduce demand significantly to slow the pace of inflation. At this point, no one really knows how far interest rates might have to rise to bring inflation down to around 2%.

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