How Does Raising Interest Rates Help Fight Inflation? Let’s Connect the Dots

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If you’ve been monitoring the news lately, you’re probably well aware of the “two I’s” that have been dominating the financial headlines: inflation and interest rates. Both have been garnering lots of attention these days.

Average inflation rates have been on an upward march in the U.S. since March 2020, peaking at 9.1% in June 2022 before dipping a bit in July and August. When inflation rates are high, goods and services cost more, which means consumers have a harder time affording what they need. Essentially, your dollar won’t go as far as it once did.

Interest rates have also risen steadily since hitting record lows in mid-2021. In recent months, the 30-year mortgage rate has been dancing between 5% and 6%, considerably higher than the 2.87% seen during this period in 2021.

On Sept. 21, the Fed gave the rates another upward nudge — three-quarters of a percentage point, to be exact — in an effort to combat surging inflation. The September increase marked the third consecutive interest-rate rise of 0.75 percentage point and represents the biggest Fed-driven spike since 1994. If you’re wondering how this helps to curb inflation, and whether it might have some undesirable trickle-down effects, allow us to shed some light on the situation. We did some digging and spoke to some seasoned finance and mortgage experts to help us (and you) understand the motivation behind such a move.

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What causes inflation to spike?

Some degree of inflation is normal in a healthy, thriving economy — in fact, the Fed aims for a target of 2% each year — but abnormally escalating inflation rates can cause an overall economic slowdown.

There are several different factors that contribute to escalation inflation:

• Supply chain issues: When there’s a shortage of goods, manufacturers have to pay more for the materials they need to produce the products they sell, and that cost increase is passed onto the consumer in the form of higher prices.
• Supply and demand: Strained supply chains can lead to a shortage of all kinds of products, from cars to clothes. When consumers have cash on hand and demand remains high, suppliers can’t keep up, which causes prices to go up.
• Worker shortages: When companies can’t find the employees they need to produce goods or provide services, this means they can’t keep up with customer demand, which then leads to price increases. Another factor is that businesses are forced to pay employees higher wages to attract and retain them, which also contributes to higher prices.

The rising cost of housing has also been cited as a cause of inflation in our current market.

Who controls interest rates?

The U.S. Federal Reserve — also known as America’s central bank or simply the Fed — was created in 1913 to serve as a safe and reliable financial system for the country. It’s also the institution that commercial banks in the U.S. rely on for some of their critical banking needs. The main jobs of the Fed are to keep unemployment and inflation rates low.

When banks need to borrow money from the Fed, they are charged an interest rate — just as a home buyer is charged an interest rate when they take out a mortgage loan from a bank. The rates themselves are set by the Federal Open Market Committee (FOMC), a branch of the Federal Reserve that is made up of five Federal Reserve Bank presidents and seven governors of the Federal Reserve Board. The FOMC meets several times throughout the year to decide what the interest rates should be at that time.

How does the Fed’s interest rate influence the economy?

The interest rate set by the Fed dictates how much it costs commercial banks to borrow from them. When those rates go up, the banks must pass the cost onto their customers who are borrowing money for home loans, car loans, and other large expenses.

While the Fed sets that general outbound rate, commercial rates do have the ability to set their own rates based on their individual business models and operations. That’s why rates will differ depending on which lender you choose — which means it’s always important to shop around at various lenders to find the best available interest rate.

When the Fed triggers a change to interest rates, it will have a trickle-down effect on the overall economy, although it can take up to a year for the impact to be felt.

How does raising interest rates counteract inflation?

Robert Massa, a financial advisor and retirement expert with Qualified Plan Advisors in Houston, Texas, notes that when the Federal Reserve raises interest rates, the cost of borrowing becomes more expensive — not just for mortgages, but also for credit cards, personal loans, corporate loans, and any other type of financing. This ultimately affects consumer demand throughout the economy, as people and businesses start cutting back on their spending and debt. As demand falls, companies respond by gradually slowing down the rate of inflation for the prices of their products and services.

“In a period of high inflation like the one we are in now, the Federal Reserve attempts to slow down the economy by reducing the amount of reserve cash banks have available to loan out to borrowers,” Massa explains. “With fewer dollars available to borrowers, interest rates climb. As rates climb, fewer and fewer borrowers are capable of — or interested in — borrowing money at these higher rates. This is because the cost associated with borrowing money to acquire what you’re looking to purchase or finance becomes less and less attractive.”

Shad Elia, CEO of New England Home Buyers, points out that the end goal is not to have zero inflation, but rather to reach the Federal Reserve’s target inflation rate of 2%, which is considered to be an appropriate level for an expanding economy.

How can raising interest rates cause a recession?

While nudging interest rates higher can help curb inflation, Joseph Hogue, CFA and investment expert at Let’s Talk Money on YouTube, says the Fed must walk a fine line. Hiking them too much can send the economy into a recession, which is when there is a decline in economic activity for two quarters in a row.

“If the cost of borrowing is too high, companies turn to cutting costs instead of just borrowing at cheap rates,” Hogue explains. “Some of these saved costs will come from layoffs, and as the unemployment rate increases, that causes a drop-off in consumer spending, which powers two-thirds of the economy.

As Hogue notes, all of these changes typically take a while to kick in, which means the central bank can’t measure the effect on the economy until six months to a year after the interest rates are increased. “Don’t raise rates fast enough, and inflation continues to build. Raise rates too high, and it leads to a recession later in the year,” he cautions.

But that doesn’t mean a recession is a foregone conclusion. Ideally, the Fed aims to achieve a soft landing, which is when the economy comes to a gradual slowdown — just enough to curb inflation without causing a dramatic downturn. According to Princeton economist Alan Blinder (via NPR), a “perfect” soft landing is a rarity, but it did occur in the mid-90s when he was vice chairman of the Federal Reserve. The Fed bumped the interest rate from 3% to 6%, which slowed down economic growth without hurting the job market or decreasing the GDP (Gross Domestic Product).

Aside from that ideal example, Blinder pointed out six other cycles between 1965 and 2020 when the interest rate was hiked with only minimal economic fallout. “The moral of the story to me was, softish landings are not as rare as was thought,” Blinder told NPR.

How does this apply to home prices?

In the U.S., home prices increased at a rate of 19.3% between February 2021 and February 2022. That means a $300,000 home in February 2021 had an inflated value of $357,900 in February 2022. Then, as interest rates began to increase, home prices from May 2021 to May 2022 increased at a rate of 18.3% between May 2021 and May 2022. By the end of June 2022, the rate of home purchase contracts had dropped by 20%.

Nearly a third of the Consumer Price Index (CPI) that the Bureau of Labor Statistics uses to track inflation is the “shelter” component, which represents the cost of housing. Other components include things like food and energy costs. All combined, these price increases can have a significant impact on consumers.

Impact on buyers

When a buyer gets a loan to buy a house, the lender will apply an interest rate to that loan, which is essentially the price the buyer pays to borrow money. When the Fed raises the interest rate to counteract inflation, that has an impact on consumers’ buying power.

“Buyers were still interested in buying, but the effects of rising interest rates were beginning to take a toll on home price inflation as some buyers began to be squeezed out of the marketplace,” explains Massa.

But despite the rising interest rates, some industry experts believe this may be the perfect time to snatch up a home. Janet Patterson, loan and finance expert at Highway Title Loans, has worked in the financial service industry for over a decade, points out that it’s often better to buy a house when mortgage rates are higher because that will cause more properties to come on the market, putting downward pressure on prices. This means a buyer could afford a larger, higher-value home at the same monthly payment they would have had for a smaller home.

Impact on sellers

On the other hand, people who are trying to sell a home during an interest rate spike may receive fewer offers and may ultimately be forced to make price adjustments. There’s also a greater chance of buyers making lower offers, paying with cash, or including contingencies in their offers.

“Higher rates can make moving a difficult decision,” says Hogue. “If they have locked in a low rate on their existing home, it will be more expensive to get a new mortgage when moving.”

Patterson says it’s best to sell when interest rates are falling because this causes an influx of new buyers to the market. “These buyers have been waiting for rates to fall, so they’re keen to get into a property immediately,” she explains.

What will happen next?

The only certainty about the economy is that it’s uncertain. That said, experts often make predictions based on the patterns they’ve seen over the years. Patterson expects inflation to decelerate in the next year. If that happens, it would mean mortgage rates will decrease as the federal government looks to establish stability.

“It should start a butterfly effect, where the Feds can cut down interest rates as well using the stable economy,” she predicts. “I would project price pressure to swing from inflationary to deflationary by 2023, taking advantage of the supply constraints.”

If you’re considering selling your home and are wondering how the current economic climate may affect your chances of success, there are a couple of smart first steps you can take:

• Contact an experienced real estate agent who can provide guidance and advice.
• Use our Home Value Estimator to get your home’s ballpark market value in minutes.
• Consider the advantages of accepting a cash offer for your home in the face of rising interest rates.

Header Image Source: (Pontus Wellgraf / Unsplash)