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22 Sep

How Does Raising Interest Rates Stop Inflation?

The Federal Reserve has been raising interest rates as it races to tamp down rapid inflation. These moves have a lot of people wondering why rate increases — which raise the cost of borrowing money — are America’s main tool for cooling down prices.

Inflation right now is being driven by an economic mismatch. Consumer demand for goods and services has been chugging along, supply has not kept up as transportation snarls and factory shutdowns combine with labor shortages to slow production, and the clash has allowed companies to charge more for the products they sell.

The Fed’s tools are blunt, and they can work on only one side of that equation: Demand. Central bankers cannot fix roiled supply chains. But their higher interest rates can slow down the economy enough that businesses and households feel the pinch, which should in theory translate into slower wage growth, less spending and lower prices.

That process is obviously a painful one. So why is the Fed doing this?

America’s central bank has for decades been what Paul Volcker, its chair in the 1980s, called “the only game in town” when it comes to fighting inflation. While there are things that elected leaders can do to combat rising prices — raising taxes to curb consumption, spending more on education and infrastructure to improve productivity, helping flailing industries — those targeted policies tend to take time. The things that Congress and the White House can do quickly help mainly around the edges.

But time is of the essence when it comes to controlling inflation. If price increases run fast for months or years on end, people could start to adjust their lives accordingly. Workers might ask for higher wages to cover their climbing expenses, pushing up labor costs and prompting businesses to charge more. Companies might begin to believe that consumers will accept price increases, making them less vigilant about avoiding them.

By making money more expensive to borrow, the Fed’s rate moves work relatively quickly to temper demand. As buying a house or a car or expanding a business becomes pricier, people pull back from doing those things. With fewer consumers and companies competing for the available supply of goods and services, price gains are able to moderate.

The risk is that the Fed’s process could come at a hefty cost given today’s dynamics. The supply of goods, while improving somewhat, remains constrained — cars are still hard to find because of semiconductor shortages, furniture remains on back order, and jobs are more plentiful than laborers. Bringing the economy back into balance could therefore require a big decline in demand. Slowing the economy that meaningfully could tip off a recession, leaving workers unemployed and families with lower incomes.

Jerome H. Powell, the Fed chair, acknowledged that the path ahead could be fraught.

“While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses,” he said in a recent speech.

But central bankers believe that even if the risks are difficult to bear, they are necessary. A downturn that pushes unemployment higher would undoubtedly be painful, but inflation is also a major impediment for many families today. Getting it under control is critical to putting the economy back on a sustainable path, officials argue.

“A failure to restore price stability would mean far greater pain,” Mr. Powell said last month, later adding that “we will keep at it until we are confident the job is done.”

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