Why did the Fed raise interest rates

Grocery prices, sofas, and rents are rising rapidly, and Federal Reserve officials have been cautiously eyeing that trend.

On Wednesday, they took the biggest step yet toward addressing it, Raising the interest rate on their policy by a quarter of a percentage point.

This small change carries a major signal: Policy makers are fully focused on the anti-inflation situation and will do what is necessary to ensure that price gains do not remain hot for months and years to come.

The Fed is acting in a tense moment for many consumers and investors. Here’s what happened and what it probably means for markets and the economy.

The Fed raised the federal funds rate, which is a short-term borrowing cost for banks, in what officials indicated was the first in a steady series of moves. Changes in Fed policy are flowing through Other types of interest rates – On mortgages, car loans and credit cards. Some interest rates that consumers pay to borrow money Previously Move higher in anticipation of the upcoming Fed adjustments.

Policy makers expected six more increases of the same size this year.

That’s because inflation is hot.

The policy changes come at a challenging time for central bankers: They are responsible for maintaining price stability, and inflation is running at its fastest pace in four decades. While officials expect price gains to moderate this year, the speed and extent of that will be uncertain, especially as the war in Ukraine raises fuel costs and threatens new virus-related restrictions in China. Continuing supply chain disruptions.

The Fed is also responsible for promoting maximum employment, but with faster hiring and more open jobs than available workers, that goal appears to have been achieved, at least for the time being.

The idea behind raising interest rates is simple: Higher borrowing costs can slow inflation by dampening demand. When borrowing is more expensive, fewer people can buy homes and cars, and fewer businesses can afford to expand or buy new machines. Spending is going down (something we I’m already starting to see). With less activity occurring, companies need fewer workers. Lower demand for labor leads to slower wage growth, which further slows demand. Higher rates effectively pour cold water on the economy.

Fed changes may also hurt the prices of stocks and other assets.

The effects of higher interest rates may appear in the markets. Higher interest rates tend to lower stock prices eventually — partly because they cost companies more to operate when money is too expensive to borrow, and partly because Fed rate increases have a track record of beating recessions, which is horrific for stocks. Higher priced borrowing costs also tend to affect the value of other assets, such as homes, as potential buyers shy away from the market.

The Fed is also preparing to shrink its balance sheet for bond holdings, and many economists expect Fed officials to release a plan to do so as soon as May. This can raise long-term interest rates and possibly lead to lower stock, bond and home prices.

The goal here is a quiet landing.

You may be wondering why the Fed would want to slow the economy and hurt the stock market. The central bank wants a strong economy, but sustainability is the name of the game: Less pain today could mean less pain tomorrow.

The Fed is trying to bring down inflation to a level where an increase in prices does not affect people’s spending choices or daily life. Officials hope that if they can slow the economy down enough to reduce inflation, without hurting it so much that it leads to recession, they can pave the way for a long and steady expansion.

“I think it’s more likely than otherwise that we can achieve what we call a soft landing,” Powell said during his recent testimony to lawmakers.

The Fed has eased the economy easily before: in the early 1990s, it raised rates without raising unemployment, and seemed to make a soft landing before the pandemic, having raised rates between 2015 and 2018.

But economists have warned that it could be tough business this time around.

“I wouldn’t rule it out,” said Donald Cohn, a former Federal Reserve vice chairman, of the soft landing. But he said suppression of demand that has led to high unemployment is also possible.