The interest rate. It affects everything from the housing market and commercial real estate to employment and student loans. With inflation at its highest level in 40 years, the Federal Reserve has raised interest rates in an effort to impede growth in business and consumer spending, which, in turn, could counter the surge inflation rates.
“Reduced demand for goods and services in the economy should ease some of the pressures that have pushed inflation higher in recent months,” said Christopher M. Herrington, Ph.D., associate professor of economics at Virginia Commonwealth University School. work.
But will it be enough? What can consumers expect? Herrington discussed the interest rate/inflation balance with VCU News.
How do interest rates affect inflation? Why is the Fed raising rates to fight inflation?
In general, the Federal Reserve uses interest rate policy to achieve its two main objectives – known as the “dual mandate” – which are maximum employment and price stability. Currently, employment looks relatively strong, but inflation is well above the Fed’s long-term target of 2%. In order to bring down inflation, the Fed is raising the federal funds interest rate as it shifts from expansionary monetary policy – which has been used to encourage economic activity in recent years – to a policy more restrictive currency. Higher interest rates will increase borrowing costs for consumers and businesses, prompting consumers to cut spending on things like homes, cars, furniture and appliances. Similarly, businesses will reduce their investment in new capital goods, such as buildings, equipment, computers, etc. Falling demand for goods and services in the economy should ease some of the pressures that have pushed inflation up in recent months.
Is there a risk that interest rates will become too high?
The Federal Reserve is certainly cautious about raising interest rates too much or too quickly, as it balances competing risks. On the one hand, the Fed wants to raise interest rates enough to curb inflation and restore price stability, but on the other hand, the Fed does not want to reduce consumption and investment demand to the point that the economy falls into recession. This balancing act is at the heart of the dual mandate, and it is one that the Fed is weighing very carefully. Of course, there are differences of opinion within the Federal Open Market Committee (FOMC) as to the appropriate pace to tighten monetary policy (i.e. raise interest rates), but I expect us to continue to see interest rate increases at a steady pace for at least the next few FOMC meetings. Ultimately, however, the Fed is “data driven,” meaning it will react to what it sees in the data. As Chairman Jerome Powell recently noted, the FOMC is prepared to keep raising interest rates until it clearly sees that inflation is coming down. He also indicated that the FOMC was ready to act more aggressively if necessary or to slow the pace of interest rate hikes if inflation returned more quickly to the target.
How are consumers affected by rising interest rates? What do we need to know?
Many of the interest rates consumers pay – for example on mortgages, auto loans and student loans – are closely tied to Federal Reserve interest rate policy. As the Fed has recently raised rates, I’m sure many consumers are already feeling the effects of these higher rates. This year alone, we’ve already seen average 30-year mortgage rates rise by about 2 percentage points, and interest rates on federal student loans are also expected to rise on July 1. In short, we can expect virtually all forms of borrowing to become more expensive, and as I mentioned before, this should dampen demand for consumer goods somewhat. On the other hand, however, consumers who have assets in savings accounts, money market accounts, CDs or Treasury securities may benefit from higher interest rates as the yields on these investments increase. It’s really important to keep in mind that consumers are very heterogeneous, and so the effects of higher interest rates will be felt very differently by different people.
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