How Do Higher Interest Rates Bring Down Inflation?

It’s nasty out there.

Inflation is high, interest rates have been rising, and bond and stock prices have plummeted. Predictions of a possible recession are proliferating.

Clearly, this is a difficult moment for anyone who has saved or invested money — or is even thinking about doing so. Many people have questions.

So we invited readers to send a brief note, asking whatever they wanted to know about what was happening in the markets and the economy, and what it might mean for their financial life.

More than 140 questions arrived. They covered just about all of the pressing financial topics, including questions about inflation; the economy’s prospects; the state of the stock, bond and commodity markets; retirement and portfolio issues; and guidance for people who are just beginning to invest or come to grips with the current markets.

While I’ve been reporting and writing about finance and investing for more than 20 years, and on other subjects even longer than that, I certainly don’t have all the answers. But I do what journalists always do: find an expert who does.

The Role of Interest Rates

Many questions dealt with inflation and interest rates, which is our topic this week.

I’ve received help from two experts.

One is Kathy Jones, chief fixed-income strategist at the Schwab Center for Financial Research. The other is Edmund S. Phelps, a Columbia University economist who won the Nobel Prize in economic science in 2006. He won the prize for his pathbreaking work on the trade-offs among inflation, wages and unemployment, and on how people’s expectations about inflation may affect inflation itself.

The central question came from Karen van Kriedt in Marin County, California, who wrote, “How does raising interest rates counteract inflation?”

In a subsequent phone conversation, she said she wanted a better understanding of what inflation really is, and of how the Federal Reserve’s actions end up affecting inflation in the real world. Her question looks simple, but its implications are profound.

The inflation situation is fairly grim. On Wednesday, the government issued fresh numbers for the consumer price index. Even the good news contained disturbing elements.

For the first time in months, annual inflation moderated in April. It’s possible that, as I’ve been suggesting since February, inflation is near a peak, with the problems caused by the pandemic beginning to ebb. Nevertheless, the index still increased at an annual rate of 8.3%, which is near its fastest pace since 1981. It’s clearly much too high.

In addition, core inflation — which excludes groceries and gas — picked up 0.6% in April from the previous month, faster than its 0.3% increase in March. That’s not a good sign.

The Fed is tightening monetary policy to fight inflation. More precisely, it is raising the short-term interest rate it controls directly, known as the federal funds rate. It is also reducing its own bond holdings and providing what it calls “forward guidance,” which amounts these days to a series of warnings that interest rates will rise further. The Fed’s actions have contributed to the turmoil afflicting the markets.

Supply and Demand

As van Kriedt and I discussed, inflation occurs when too much money chases too few goods. When people have a lot of cash and not that much to spend it on, they often bid up prices. “Like they are doing with houses here in Marin County?” she asked.

Exactly, I said.

Jones and Phelps explained the mechanics of how inflation works.

So how might raising interest rates help here? One way of looking at rapidly rising prices — aka, a high rate of inflation — is as an imbalance of supply and demand. By raising short-term interest rates, and by influencing rates elsewhere in the economy, the Fed is making it more expensive to borrow money.

Mortgage rates are rising, for example, making it more costly to buy a house. That may not lower inflation in home prices immediately because the supply of materials and available workers is so tight and demand is so high, mainly because of the pandemic. The Fed can’t do much about those shortages. But as they resolve, perhaps within a year or so, higher interest rates are likely to shift the relationship of supply and demand, lowering the rate of inflation.

Jones, the strategist at Schwab, put it this way: “By raising rates, the Fed is trying to make you slow down your spending. That happens when the cost of money goes up for a car loan or mortgage or something else you want to spend money on. At some point, you’re going to pull back. The higher cost of money reduces your purchasing power — what you can afford to buy — and the Fed is effectively making you buy less. And that should bring down inflation.”

Similarly, Phelps said, “You can look at our situation as aggregate demand exceeding supply, and that’s causing prices to rise,” so the Fed needs to “clamp down on demand” by raising interest rates.

Sadly, though, he said, if interest rates go high enough for long enough, economic growth will slow and some people will lose their jobs. “When the unemployment rate turns out, after careful analysis, to be very low, and when inflation is high, then we do want to put a lid on it and the Fed does need to raise rates,” he said. “But that will have consequences.”

An economic slowdown associated with a decline in the rate of inflation could deteriorate into an outright recession. But the Fed is trying to avoid that and engineer a “soft landing” — a state of Goldilocks perfection, in which growth is neither too fast nor too slow, and prices are just right.

The Need to ‘Communicate’

Financial markets are reacting not just to what the Fed does but also to what it says it is going to do. Nick DeClerico of Philadelphia sent in a question about that.

The Fed’s pronouncements about where it expects interest rates and inflation to go are called “forward guidance.” DeClerico said he was “wondering why the Federal Reserve feels it necessary to constantly ‘communicate’ future actions to the financial markets.”

This kind of communication was less common 30 years ago. But a series of Fed chairs — Alan Greenspan, Ben Bernanke and Janet Yellen — expanded the practice. Jerome Powell, confirmed for his second term as the leader of the Fed on Thursday, has made it central.

The Fed uses official statements, publicly disseminated economic projections, speeches, interviews and news conferences to tell the markets where it wants them to be heading.

At this moment, Phelps said, the Fed may be “scaring people in financial markets into believing that they should lower their expectations of inflation.”

He added, “The Fed is saying we should believe the inflation rate is going to fall as a result of the Fed’s efforts.”

The idea is that “the markets are already expecting that the Fed is going to succeed in lowering expectations of inflation, and that will lower inflation itself.”

That’s the theory, at least. There’s some evidence that it works. Longer-term interest rates have risen substantially this year, not just as a mechanical response to increases in the federal funds rate but as a reflection of changing views in the markets of where the Fed wants interest rates and inflation to be a year or two from now.

This approach has a drawback, however. It’s like the old game of telephone. Start by whispering “higher interest rates and a soft landing in the economy,” and before you know it, this message, transmitted from person to person, has become totally different. The Fed’s messages mean different things to different people. Some people are hearing “recession.”

That, in my view, is a major reason for the heightened anxiety and volatility in the markets. There is no stable consensus on where the Fed is going or whether it can get there.

Phelps is skeptical, too. “I have no idea how much importance to attach to that thinking, that forward guidance,” he said. “Lots of people will have their own thoughts about future Fed policy, and I’m not sure that their expectations can be directly manipulated in this way, but it’s an interesting question. Really, I don’t know to what extent central banks are effective in altering expectations of inflation, of guiding people to a particular rate of inflation.”

The Fed’s efforts to combat inflation are a grand experiment. Like it or not, we’re all part of it.