In a two-day policy meeting that ended Wednesday, the U.S. Federal Reserve announced plans to phase-out large-scale bond-buying in preparation to raise interest rates. Rate hikes could begin as soon as Spring 2022 and come in three separate instances, PBS reported. By comparison, the benchmark rate has been near zero since the start of the pandemic. So how will the increases affect inflation and the economy at large?
The bond tapering and interest rate hikes represent the Fed’s attempt to fight inflation. “The risk of higher inflation becoming entrenched has increased,” Fed chairman Jerome Powell told reporters during a press conference following the meeting. “It’s certainly increased. I don’t think it’s high at this moment, but I think it’s increased. And I think that’s part of the reason behind our move today.”
Previously, NPR reported, the Fed had used the word “transitory” to describe pandemic-related inflation. The Fed continues to take the stance that the inflation is still largely driven by pandemic-related factors such as supply chain issues and product shortages, but are also acknowledging other concerns about inflation.
Powell said, “High inflation imposes significant hardship, especially on those least able to meet the higher costs of essentials like food, housing and transportation.”
But will raising interest rates really help stem inflation? Traditionally, when interest rates are high, people tend to stop borrowing and, ideally, begin saving money. They might work harder to pay down debt, resulting in having less discretionary income to spend. They might keep money in the bank or invest it in higher-yield online savings accounts, CDs, or mutual funds. They are less likely to borrow money.
The Quantity Theory of Money purports that the laws of supply and demand relate to money supply, as well as goods and services. If there is more money out in the economy, prices will rise because the value of the dollar is actually worth less (since there are more of them available).
On the other hand, if we tighten the money supply by saving money and the Fed doesn’t print more, the value of the dollar rises, and prices should remain stable or even fall.
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Experts say that interest rate hikes should help curb inflation in 2022, but would still leave interest rates below historic levels, allowing for economic expansion. Additionally, if the transitory, pandemic-related factors causing inflation this time around also taper off — such as shortages of critical products — that could also help slow inflation.
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