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How raising interest rates helps fight inflation and high prices

The Federal Reserve has increased the key interest rate three times so far this year as the price of consumer goods keeps rising.

The Federal Reserve announced Wednesday an increase in its key interest rate by 0.75% to help fight inflation and get price growth under control.

The reasons the U.S. is in this economic environment are complex, but can be boiled down simply: There is too much demand and not enough supply. As Federal Reserve Chairman Jerome Powell said Wednesday, "Aggregate demand is strong, supply constraints have been larger and longer lasting than anticipated, and price pressures have spread to a broad range of goods and services."

Notably, he said, the surge in prices of crude oil and other commodities that resulted from Russia’s ongoing invasion of Ukraine has been boosting prices for gasoline and food, creating additional upward pressure on inflation.

By raising interest rates, the Federal Reserve hopes to tackle high prices and reduce demand by making it more expensive to borrow money.

But how does raising interest rates do that, exactly?

When you get a loan from a bank — for example, when you're buying a house — an interest rate is attached to that loan. The interest rate is the price you pay to borrow the money.

The Federal Reserve is America's central bank. Its primary role is to provide a safe and reliable financial system for the U.S. It's the institution that commercial banks rely on for some of their critical banking needs.

One critical need is maintaining deposit accounts, also known as reserve accounts. It's the same idea as having a deposit account at a regular bank — only in the case of most American banks, there is a requirement that they keep a certain level of financial reserves on hand.

When banks need to borrow money to replenish those reserves, they look to other banks that have reserve accounts with the Fed and that may be in a surplus.

And just as with any other loan, the banks are charged an interest rate, too. It is this percentage, known as the federal funds rate, that the Federal Reserve helps determine.

How the federal funds rate influences parts of the economy

But how could one interest rate have so much influence on the broader economy?

Banks pass on the cost of a higher federal funds rate to their customers when those customers want to access regular lending products.

The best example is the prime rate. This is the interest rate banks charge their most creditworthy borrowers, like large corporations. For several decades now, the rule of thumb has been that the prime rate is equivalent to the federal funds rate plus 3%. So, with the new federal funds target rate at between 1.5% and 1.75%, the new prime rate at the upper range would be at 4.75%. The percentage difference is supposed to cover the cost of processing a bank loan.

Changes in the prime rate, in turn, drive up the cost of borrowing for all other loan products, like real estate and vehicle purchases, as well as revolving debt such as credit cards.

As the theory goes, if it’s more expensive to borrow money or carry a balance on a credit card, consumers will spend less. When spending declines, demand will fall and, eventually, so will the price of everyday goods.

There is a risk, however. Economists warn the combination of higher borrowing costs, high inflation, and slower growth could tip the U.S. economy into a recession. So the onus is on the Federal Reserve to choose its moves carefully.

"The risk of recession is higher than before [Wednesday's] meeting, because the Fed expects to hike so much further, and more rapidly, than previously," wrote Pantheon Macroeconomics Chief Economist Ian Shepherdson in a note to clients Thursday.

Does raising interest rates actually work?

In his speech Wednesday, Powell said he is seeking to bring demand more in line with supply. But the global supply chain for a wide array of products has been severely constrained over the course of the pandemic, due in part to strict Covid-19 policies in China where many mass-produced goods are sourced.

The ongoing war in Ukraine has negatively affected the global food supply in addition to the crude oil and natural gas resources that Europe largely depends on.

So, there may only be so much the Federal Reserve can do with the tools it has available.

"Goods inflation is a trade and geopolitics issue that's controlled by government as a whole and not the Fed," said Derek Tang, an economist at LH Meyer Inc., a macroeconomic consulting group.

"We'll have to look to the White House and Congress to act on those issues, whether that means brokering deals with other countries to make sure we have better supply, or have more access to supply," Tang said.