Why the Federal Reserve Raised Interest Rates (A Lot)

It is not challenging for one to see the effects of inflation these days. Across the world, prices have risen for a variety of products and goods, to varying degrees. Oil and gas, food and other household items have all been increasingly expensive at alarming rates. These past few months have seen worrying signs that the economy is heading deeper into a recession. This year in April, the labor department announced the single biggest increase (8.5%) in the Consumer Price Index (CPI) since 1981. Earlier this May, the US Federal Reserve (also known as “the Fed”) decided to raise interest rates for corporations (including banks) looking to borrow money from the US government. Although the Federal Reserve is typically a cautious institution when it comes to enacting radical policy changes, it decided to raise its interest to a dramatic degree, the largest raising of its interest rates in over 20 years. Here is how we have assessed inflation has been rising and why the Fed has decided to raise the interest rate to such a degree and take a gamble that could easily worsen the recession.

The Consumer Price Index measures the cost of living/inflation in a given area by using a collection of different products that consumers buy (including clothes, food, medical care, education costs, etc), to compare and contrast any change in those prices. Differences in the CPI can be measured between countries or different time periods and these differences in the CPI measure changes in inflation rates as well. After all, the term “inflation”, is used to describe the decrease over time in purchasing power for a certain amount of money in a given currency. In other words, if you can buy less goods and services with the same amount of money in a month from now, your currency’s inflation has increased. For example, if the price of bread one year ago in the US was on average $10 and next year the average price jumped to $15, the price for bread has been inflated to 150% of the price a year ago.

However, a rise in the price or inflation of a specific good (for example, bread) does not inherently imply the overall economy is experiencing a rise in inflation. Using the earlier example of the bread, if the price of bread increases to 150% of its value a year ago, the rise in price could be the result of some specific reason for bread to be more expensive (for example, a specific machine that is used to make the bread becomes more expensive) and prices for other goods and products might stay relatively the same in this case. However, simultaneous rising prices for a range of different products raises the CPI and indicates a rise in inflation.

There have been a number of factors that have been causing the rising prices. Major logistical issues with shipping companies have caused prices of all goods to rise on some level, because when products are more expensive to buy (because of increased shipping costs) businesses will raise their prices for their customers, instead of receiving a lower profit margin. An owner of a nearby supermarket gave a succinct description of this phenomena when he said to me “when my prices go up, yours do too”. Additionally, the war in Ukraine has sent oil and gas prices skyrocketing around the world, as much of the Western world attempts to find an energy supplier that is close to as cheap as Russia. Aside from fossil fuels, Russia and Ukraine export more than 25% of the global wheat supply, causing the prices of wheat products to soar as well.

The body tasked with managing dire situations such as rising inflation is the US Federal Reserve, which is also the national bank of the US government. Its responsibilities as an institution include monitoring the money supply and deciding how much US currency to print, setting interest rates and a variety of other responsibilities that are involved in protecting the American economy and fostering economic growth.

When the Federal Reserve raises the interest rates, it becomes more expensive for businesses and banks to borrow money from the government and in general. So the idea would be to raise the value of the dollars already in circulation by making loans harder to acquire. After all, if printing currency causes inflation to rise, slowing the release of more currency into circulation by raising the interest rates (and therefore the cost of borrowing money from the government) should cause the value of money to stabilize, because it costs more to get.

The chairman of the Fed Jerome Powell explained his move to raise interest rates as part of the Fed's efforts to move “expeditiously to bring it [inflation] back down”. Powell addressed concerns that the move could exacerbate issues within the economy by arguing that “businesses are in very good shape” and that “the labor market is very, very strong”. However, making money more expensive to borrow may lead to a drop in individuals and businesses investing money in developing businesses, which could lead to a further slowing of economic growth that impacts levels of unemployment as well, since companies may be forced to lay off workers (and ask the remaining workers to do more) and/or reduce or terminate their expansion plans. It is important for the Federal Reserve to succeed in its gamble (of raising interest rates). If this move does not work out it could end up worsening an already volatile and sluggish economy, by decreasing investment and increasing unemployment. American citizens had better hope the Federal Reserve succeeds in its gamble, because if not, things in the economy will get a whole lot worse in the economy before it gets better.