Ask the Advisor: June 2022

Q:  The Federal Reserve increased interest rates “to put the brakes on inflation.”  How does that work?  Wouldn’t I pay higher costs when credit card companies raise interest rates?  

A:  TSCL believes that putting the brakes on inflation might take some time and that higher prices will continue for some months yet.  Any measures taken by the Federal Reserve to slow inflation by raising interest rates need to be introduced very carefully to avoid causing an economic recession.  Meanwhile, consumers living on fixed incomes need to plan to keep balances carried on credit cards and other consumer loans manageable, because the cost of debt is going up.

Inflation is currently at levels unseen for about 40 years, and consumer prices have reached the highest level of inflation since 1981.  In March, Fed Chairman Jerome Powell announced several expected interest rate increases this year which would affect what businesses and consumers pay to borrow.  Not only will the cost of carrying debt on credit cards rise, but so will the costs of other types of loans.

Raising interest rates is the main tool that the Fed uses to slow inflation.  As you have noted, when the cost of borrowing increases, banks and businesses pass these higher costs on to consumers.  That, in turn, makes borrowing more expensive, and many consumers may decide not to buy right now, or to reduce their spending in some other way.  Thus, the demand for many goods and services tends to go down, and that slows the rate of price increases.

Economists warn, however, that due to continued supply chain disruptions and shortages, some prices may not necessarily go down, but the rate of inflation would come down as price increases slow.

The risks are in raising interest rates too quickly.  Raising rates too much too quickly could increase the risk of recession.  There are geopolitical tensions outside of the Fed’s control that also affect prices, particularly for gas and oil products.  The conflict in Ukraine adds to a global shortage of oil, corn, and wheat, which will tend to sustain higher prices for these products.