With the Fed raising interest rates 11 times between March 2022 and July 2023, almost all Americans were affected by these series of decisions. The Fed raised interest to combat inflation, but what is interest, and how does it impact inflation?
When a bank loans a borrower money, they run the risk of not receiving the money back for an extensive time. In order to penalize the borrower for using lended money, the borrower must pay an additional fee for borrowing the lender’s money, interest. The Federal Open Market Committee (FOMC) controls interest rates by setting a target range for federal fund rates, the interest rate at which banks borrow and lend each other money. If the FOMC raises the federal fund rate, banks are more likely to lend out money, and if the FOMC decreases the federal fund rate, banks are less likely to lend out money. In addition to the federal fund rate, there is also a discount rate, the interest rate the Federal Reserve charges banks that borrow from it directly.
The Fed changes the federal fund rate according to the state of the economy. In order to combat inflation, an increase in the price of goods and services and fall in purchasing power, the Fed increases the federal funds rate, meaning it costs more to borrow money, leading there to be a smaller supply of money for consumers to make purchases. This in turn leads to people saving more and less demand on goods and services, eventually leading to the economy cooling down, and inflation decreasing. In order to combat deflation, the Fed does the opposite. They lower the federal fund rate, making money cheaper to obtain. This leads to more frequent and bigger purchases, stabilizing the economy. The Federal Reserve makes these decisions based on factors such as the Consumer Price Index, how much an American consumer pays, and the Producer Price Index, prices producers receive for their output.
Recently Federal Reserve Chairman, Jerome Powell reported that the Central Bank is now deciding when to start decreasing interest rates. Interest rates increasing may cause an economic downturn, but decreasing interest rates too soon means inflation would settle above the Federal Reserve’s goal of 2%. Powell states that the Fed will take their time when making this decision because inflation is steadily decreasing and other factors in the US economy are stable.
Correlation between CPI and the Federal Fund rate 1950s- 2010s
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