Inflation surged by 7.9% through February 2022, reaching a new 40-year high since January 1982. Gas accounted for nearly a third of that increase, and food and rent were also large contributors to the jump. On Thursday, gas prices reached their highest recorded average of $4.31 per gallon, and grocery prices are steadily rising, with their highest increase since April 2020. As the effects of soaring prices are being felt in everyday purchases, more Americans are living paycheck-to-paycheck, and wages are not keeping up with inflation rates.
So what exactly is inflation? Simply put, inflation is a sustained increase in consumer prices over a period of time. This means that your dollar has less purchasing power, making everything you buy more expensive even though you’re likely not getting paid more.
With inflation hitting record highs, the Federal Reserve, the government body in charge of keeping inflation in check, is under a great deal of pressure from policymakers and consumers to get the situation under control. One of the Fed’s primary tenets is to promote price stability and maintain inflation at a rate of 2%.
To counteract inflation’s rampant growth, the Fed plans to raise interest rates as soon as this month. Raising interest rates helps slow down the economy — a good thing in this case. By making borrowing more expensive, consumers, investors and businesses pause on making investments, which reduces demand in the US economy and reels back prices.
So how did we get here and what should you be prepared for? I’ll walk you through how this happened, what the Fed is doing about it and what rising interest rates mean for you.
Why did inflation get so bad?
We’re here because of the pandemic.
In March 2020, the onset of COVID-19 caused the US economy to shut down. Millions of employees were laid off, many businesses had to close their doors and the global supply chain was abruptly put on pause. This caused the flow of goods shipped into the US to cease for at least two weeks, and in many cases, for months, according to Pete Earle, an economist at the American Institute for Economic Research.
But the reduction in supply was met with increased demand as Americans started purchasing durable goods to replace the services they used prior to the pandemic, said Josh Bivens, director of research at the Economic Policy Institute.
“The pandemic put distortions on both the demand and supply side of the US economy,” Bivens said. “On the demand side, it channeled tons of spending into the narrow channel of durable goods. And then, of course, that’s the sector that needs a healthy supply chain in order to deliver goods without inflationary pressures. We haven’t had a healthy supply chain overwhelmingly because of COVID.”
This increased demand combined with the supply chain kinks induced inflation, which has persisted since the 2021 reopening of the economy.
That noted, inflation isn’t inherently a good or bad thing. Moderate and steady inflation is actually important for a healthy economy: It promotes spending since rising prices encourage consumers to buy now, rather than later, keeping demand up. Inflation can become a problem when it rises over 2% (as measured by the Fed) and when it rises rapidly. That messes with healthy consumer spending and, in extreme cases, can derail price stability.
What is the Fed doing about inflation?
The Fed announced in January that it will “soon” be appropriate to raise interest rates in order to slow inflation, with broad support from Federal Open Market Committee members. (The FOMC is the Fed’s monetary policymaking body.)
But how does raising rates help reduce inflation, exactly? When interest rates are raised, the cost of borrowing is increased, which leads to a decrease in consumer demand in the economy. This helps balance the supply and demand scales, one cause of inflation that was thrown out of whack by the pandemic.
“In light of remarkable progress in the labor market … the economy no longer needs sustained high levels of monetary support,” said Federal Reserve Chairman Jerome Powell during the press briefing in January.
Interest rates have been at historic lows, partially because the Fed slashed interest rates in 2020 to keep the US economy afloat in the face of lockdowns. Since then, the Fed has kept interest rates near zero, which has only been done once before during the financial crisis of 2008. Interest rates are already on the rise as, for example, 30-year fixed mortgage rates are returning to pre-pandemic levels.
In his semiannual testimony to Congress, Powell said he is “inclined to propose a 25 basis point rate hike” which would equate to a 0.25% increase. Moving by quarter intervals is the typical move for the Fed, according to Earle. An official decision is expected when the FOMC concludes its March 15-16 meeting — the second of eight FOMC meetings held annually.
What do rising interest rates mean for you?
Raising interest rates will make it more expensive for both businesses and consumers to take on loans. For the average consumer, that means buying a car or a home will get more expensive since you’ll be paying more in interest.
This will also make it more difficult to refinance your mortgage at a lower interest rate. Moreover, the Fed’s move will also drive up interest rates on credit cards, ratcheting up minimum payments along with it.
Should you be worried about inflation?
While inflation is top of mind for many Americans, experts don’t think hyperinflation is a concern right now.
The FOMC took initial steps to counteract inflation by reducing its bond-buying program by $15 billion monthly in November 2021, a rate which was increased to $30 billion in order to accommodate potentially raising interest rates sooner than planned. Now, with interest rate increases on the horizon — and three to four rate hikes expected this year — the Fed’s plan is expected to contain rampantly growing inflation.
However, Earle said, “There’s no guarantee the Fed will necessarily act quickly enough or the right way to promptly arrest inflation and may take them longer than we think or hope.”
Beyond this uncertainty, there’s another concern on the table. If the Fed overreacts by raising rates too high, it could spark an economic downturn, or worse, induce a recession. Raising rates too quickly may hinder consumer demand too greatly and unduly stifle economic growth, potentially leading businesses to lay off workers or stop hiring. This could drive unemployment up, which would lead to another problem for the Fed which is also tasked with boosting employment.
“The more radical and the more quickly [the Fed] moves, the more they tempt the randomness that comes with the uncertainty of the market and the prospect that we may see a nasty recession,” Earle said.
Recently, Christopher Waller — a member of the Board of Governors of the Federal Reserve — suggested that a half-point interest rate increase might be warranted at the FOMC’s next meeting, as reported by the Wall Street Journal. Waller has also suggested raising rates by 1 percentage point by the middle of 2022. But Russia’s invasion of Ukraine now makes that move less likely, according to Earle.
Nonetheless, Powell signaled to Congress that the Fed will move forward with interest rate hikes in the FOMC’s next meeting despite the war in Ukraine. While the immediate effects of Russia’s invasion are surfacing, most prominently at the gas pump, the lasting effects of the conflict on the US economy remain uncertain.
