How Raising Interest Rates Curbs Inflation – and What Could Possibly Go Wrong
Rodney Ramcharan, Associate Professor of Finance and Business Economics, the University of Southern California.________
After about three decades of relatively low inflation, consumer prices are skyrocketing again in the US.
The price of gasoline, for example, was up 40% in January 2022 from a year earlier, while used cars and trucks jumped 41%, according to data released on Feb. 10, 2022. Other categories experiencing high inflation include hotels, eggs, and fats and oils, up 24%, 13% and 11%, respectively. On average, prices climbed about 7.5%, the fastest pace of inflation since 1982.
It’s part of the mandated job of the US Federal Reserve to prevent inflation from getting out of hand – and lowering it back to its preferred pace of about 2%.
To do that, the Fed has signaled it plans to raise interest rates several times this year – perhaps as many as five – beginning in March. And January’s faster-than-expected inflation figures suggest it may have to accelerate its overall timetable.
Will this work? If so, why?
I’m an economist who has been studying how monetary policy affects the economy for decades while working at the Federal Reserve, the International Monetary Fund, and now 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.
The Federal Reserve controls the federal funds rate, often referred to as its target rate.
This is the interest rate that banks use to make overnight loans to each other. Banks borrow money – sometimes from each other – to make loans to consumers and businesses. So when the Fed raises its target rate, it raises the cost of borrowing for banks that need funds to lend out or meet their regulatory
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