As the Federal Reserve tries to slow down fast inflation, it has been raising interest rates. A lot of people are wondering why rate hikes, which make it more expensive to borrow money, are the main way the U.S. brings down prices.
Right now, an economic mismatch is causing inflation. Consumer demand for goods and services has been strong, but supply hasn’t kept up because of transportation jams, factory shutdowns, and a lack of workers. This has caused companies to charge more for the goods they sell.
The Fed’s tools are blunt, and they can only affect the demand side of the equation. Central bankers can’t fix supply chains that are messed up. But their higher interest rates can slow down the economy enough that businesses and households feel the pinch. This should, in theory, lead to slower wage growth, less spending, and lower prices.
It’s clear that this is a painful process. The Fed is doing this, but why?
Paul Volcker, who was in charge of the central bank in the 1980s, said that it was “the only game in town” to fight inflation for many years. There are things that elected leaders can do to stop prices from going up, such as raising taxes to cut down on consumption, spending more on education and infrastructure to boost productivity, and helping to struggle industrializing taxes to cut down on consumption, spending more on education and infrastructure to boost productivity, and helping struggling industries. However, these targeted policies tend to take time to work. Congress and the White House can do a few things quickly that will help, but they won’t make a big difference.
But if you want to stop inflation, time is of the essence. People might start to change their lives if prices keep going up quickly for months or years. Workers might ask for higher pay to cover their rising costs, which would raise labor costs and make businesses charge more. Companies could start to think that customers will be okay with price hikes, which could make them less careful about avoiding them.
By making it more expensive to borrow money, the Fed is able to slow down demand fairly quickly. When it costs more to buy a house, or a car, or grow a business, people stop doing those things. Price increases may slow as fewer people and businesses compete for the same amount of goods and services.
Given how things are right now, there is a chance that the Fed’s process could cost a lot. Even though the supply of goods is getting better, it is still limited. Cars are still hard to find because of a shortage of semiconductors; furniture is still on backorder, and there are more jobs than workers. So, a big drop in demand might be needed to bring the economy back into balance. If the economy slows down enough, it could start a recession, which would leave people without jobs and families with lower incomes.
The head of the Fed, Jerome H. Powell, said that the road ahead could be rough.
Inflation will go down because of higher interest rates, slower growth, and a weaker job market, he said in a recent speech, but households and businesses will have to deal with some pain.
But central bankers think that the risks are necessary, even if they are hard to deal with. A recession that makes unemployment go up would be bad, but inflation is also a big problem for many families right now. Officials say that getting it under control is key to getting the economy back on a sustainable path.
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Last month, Mr. Powell said, “If we can’t get prices back to where they should be, we’ll be in a lot more trouble.” He later added, “We’ll keep at it until we’re sure the job is done.
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