How do rising interest rates affect inflation?

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Today’s economy looks very different from last year’s, and worries about inflation, market downturns and even a potential recession weigh on many Americans. In these uncertain times, it can be difficult to understand such an influx of bad news: Why might there be a recession? Shouldn’t inflation be temporary?

To help break it all down, Select spoke with economist Michael Gapen, managing director and head of U.S. economic research at Bank of America, about how rising interest rates can help curb inflation — and how that could result in a recession.

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Econ 101: Interest rates, inflation and recession?

First, inflation is defined as the increase in the prices of goods and services in an economy. In July 2022, US inflation, as measured by the Consumer Price Index, was 8.5%. This means that the cost of goods rose by an average of 8.5% year-on-year. Although not all goods and services were equally affected by inflation, categories such as food and energy saw the biggest increases.

The rise in prices across the board was caused by many different factors – the war in Ukraine led to a rise in energy prices, while supply chain shortages affected the prices of other goods, such as cars. In other words, high prices are caused by having too little of a supply of goods and services and at the same time have Too much demand for them.

This is where the Federal Reserve System comes in – its primary function is to maintain a low rate of inflation and unemployment in the United States, which it does by controlling the interest rate, or federal funds rate. By increasing the federal funds rate, the Fed makes it more expensive for banks, and thus consumers and businesses, to borrow money.

For consumers, higher interest rates mean it’s more expensive to buy big-ticket items that are typically bought with credit, such as homes, cars, furniture and large appliances, says Gapen.

As a result of a rate hike, you may end up seeing a higher annual percentage rate, or APR, on your credit card or a higher annual percentage rate, or APY, on your savings account. This means that consumers who have revolving credit card debt may see higher interest charges on their monthly statement. Those who currently have credit card debt may want to consider signing up for a card that offers an introductory period of 0% APR on new purchases or balance transfers to help get them over with.

For example, the Wells Fargo Reflect® Card is a great option with no annual fees that offers an introductory 0% APR for 18 months (after 15.24% – 27.24% variable APR) from the date of your account opening, for purchases and balance transfers made within the first 120 days. It is also possible to extend it for up to three months as long as you continue to make timely minimum payments.

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Another no-annual-fee card to consider is the US Bank Visa® Platinum Card, which offers an introductory period of 0% APR for the first 20 billing cycles on balance transfers and purchases (after 16.74% – 26.74% variable APR).

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Another potential result of higher interest rates: Businesses may pull back on borrowing and investing, meaning consumers and businesses will start spending less, eventually bringing demand back to a level that matches supply.

“An increase in interest rates helps to reduce the overall level of demand and therefore hopefully reduces the upward pressure on prices,” says Gapen.

So why might this cause a recession? In the longer term, companies can respond to consumers buying fewer goods and services by reducing production, Gapen explains. Put another way: when people start buying less goods and services, companies respond by producing less of them. According to Gapen, when companies reduce production, they also cut back on inputs and labour.

“If you slow down demand, you probably slow down hiring, and there could be layoffs, which could push unemployment up,” Gapen says. “Hopefully what you’re also doing is curbing inflation at the same time.”

In other words, when the Fed raises interest rates, it reduces the demand for goods and services, which can result in businesses hiring less or laying off their workers and potentially leading to a much-feared recession.

Bottom line

With more rate hikes predicted for the coming year, Gapen predicts it will take one to two quarters for consumers to respond with lower demand. However, it will take longer for prices to drop.

While the Fed’s actions are certain to have an impact on inflation, Gapen notes that consumers are unlikely to feel relief from higher prices until supply chain bottlenecks are resolved or geopolitical issues in Ukraine ease. Until then, consumers can be stuck paying more for gas, cars and just about everything else.

Editorial note: Opinions, analyses, reviews or recommendations expressed in this article are solely those of the Select editorial staff and have not been reviewed, approved or otherwise endorsed by any third party.

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