GOBankingRates

How Does Raising Interest Rates Help the Economy?

sefa ozel / iStock.com

The Federal Reserve’s decision this week to hike interest rates a whopping 75 basis points — the first time that’s happened in 28 years — is intended to do one thing: Tamp down the highest inflation rate in more than four decades so consumers don’t have to pay $5 for a gallon of gas or nearly $3 for a dozen eggs.

See: Fed Raises Rates 75 Basis Points Amid Bear Market & Record-High Inflation
Find Out: How Much Did Inflation Increase the Price of Bacon, Bread & Eggs in May?

Here’s how it’s supposed to work: Rising interest rates aim to cool off an overheated economy by dampening consumer spending. This in turn will lead to lower demand for goods and services and lower prices, the Washington Post reported.

The Fed’s ultimate goal is to keep prices stable while also promoting maximum employment and returning to moderate long-term interest rates, CNBC reported — all of which is good for the economy.

With inflation running so high right now — it hit 8.6% in May, the highest level since 1981 — the central bank felt like it had no other choice but to be aggressive with its latest rate hike. Most economists had expected a 50-basis-point increase, but the Federal Reserve committee opted for a bolder move.

Make Your Money Work for You

“We thought that strong action was warranted at this meeting and we delivered on that,” Federal Reserve Chairman Jerome Powell said in a news conference following the decision. “It is essential that we bring inflation down if we are to have a sustained period of strong labor market conditions that benefit all. … The current picture is plain to see: The labor market is extremely tight and inflation is much too high.”

Ideally, the Fed would like to keep inflation at about 2% a year. When the rate soars much higher than that, like now, the central bank’s main tool for fighting it is interest-rate hikes. This affects a wide range of loans, pushing rates up for everything from credit cards and mortgages to car loans. Savings account rates also move higher, which might incentivize people to put more money into savings.

The idea is to make borrowing so expensive that both businesses and consumers delay making any new investments, which will cool off demand and send prices back to normal levels.

The trick is to ensure that demand doesn’t cool so much that the economy stalls and lapses into a recession. That could lead to a slowdown in hiring, layoffs, and rising unemployment.

See: Are We Heading Into a Recession?
Find: National Gas Prices Break $5 a Gallon – What’s Behind the Ongoing Price Surge?

Just don’t expect the latest interest rate hike to have an immediate impact. As CNBC noted, it will likely take time for the Fed’s action to bring down inflation and benefit the economy. Beyond that, uncertainty over the Russia-Ukraine war — a major contributor to higher oil and gas prices — could throw an additional wrench in the economic recovery.

More From GOBankingRates