What Will Be the Effect of the Fed’s Efforts to Fight Inflation?

With prices rising significantly for families across the United States, the federal government has made controlling inflation one of its top economic priorities. One of the most important ways the government has traditionally tried to limit inflation is through the Federal Reserve raising interest rates.

Raising interest rates clearly can shrink inflation, but many Americans don’t understand that it does so by deliberately slowing down the economy. It may limit inflation, but it does so through mechanisms that may actually make things worse for many American families.

Here’s what happens when the Fed raises interest rates:

  1. Businesses that issue stocks and bonds (borrowing money) to build factories and things will borrow less money and build fewer factories and things. This is because if the business expects to make a certain amount of profit from the factory, building might make sense if interest rates are lower, but not make sense if interest rates are higher (and the higher interest costs could be more than the expected profit). The businesses will therefore not hire as many workers as would otherwise be the case to work in the factories. Fewer workers will be getting better jobs, and the workers, in aggregate, will have less money to buy stuff and there will be less ability for businesses to raise prices. This is more or less what a classic economic textbook would say.
    This is still somewhat true, but less so than in the past, as major employers today (such as Amazon) have huge amounts of cash, and have little need to take out new loans to finance expansion.
  2. Interest rates on auto loans and home mortgages will rise. This means that when you want to buy a car or a house, and you apply for a loan based on the monthly payment you can afford to make with your income, the loan that you will qualify for will be smaller than was the case previously. That means that the car seller will have to offer you a lower price, or you will have to decide to continue taking the bus. That will tend to make the price of cars go down, and reduce the number of cars that are made. That in turn will mean fewer hours for the workers in the car factories, and they (as in the case above) will have less money to buy stuff.
  3. Some people are actually better off (mostly the same people who are always better off). If you have a home or a farm or some rental property and you have been making mortgage payments for a few years — and the mortgage payments are the major expense in your life, then you could be making a little more money now (if your wages, or the prices of the produce from your farm, or the rent your charge your tenets is going up) but your major cost (your mortgage payments) is fixed. Mortgage payments are the one thing that (for most Americans who have 30-year fixed-rate mortgages) do not go up. So for those people who are already fairly wealthy, inflation is a much smaller problem than for people (about one-third of Americans) who are living paycheck to paycheck and pay rent every month.

If economists and policymakers want to argue that this is better in the long run than inflation, that’s their right. But they should be clearer with the American people about the costs associated with raising interest rates.

Raising interest rates will (by design) make many Americans poorer, and less able to afford things they want to buy. We need to stop mystifying the economy and the financial process and start being up-front with the American people about the policy trade-offs involved.

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