Raising interest rates to prod people into spending less to fight inflation may sound counterintuitive, but that’s what the nation’s Federal Reserve System is attempting. While the increments may seem small, they will affect local businesses and consumers.
“Raising interest rates is the Fed’s main tool to deal with inflation,” said retired banker Dan Blanton, who had served as CEO of Georgia Bank & Trust (now South State). “The historic data bears out that it does work if you give it time.”
On March 16, the Federal Reserve Board decided to increase its interest rate by 0.25 percent, with plans for another rate hike in the summer. Some experts believe they will eventually raise the rate by 2 percent.
The Federal Reserve, commonly referred to as the Fed, was formed in 1913 to regulate banks and to act as a stabilizing force on the nation’s economy. Regulating interest rates is one method of doing so, but its interest rate doesn’t directly apply to consumers. Instead, it affects banks.
The Fed required banks to maintain a certain level of cash in its vaults at the end of each day. Some banks end up below that level during normal business while other banks post a surplus. The banks coming up short can borrow money from the banks holding a surplus to fulfill their obligations. The interest rate for those loans is the rate set by the Fed.
Banks and other lenders then add the Fed rate to the rate they charge borrowers. Those rates vary, with banks usually among the lowest and credit cards the highest.
“It cranks up the cost of funds to the bank, which passes it on to the lenders who pass it on to the consumer and it raises the cost of items,” Blanton said.
So how does that help curb inflation?
Inflation happens when too much money is being exchanged through an increase in goods and services. By raising interest rates and subsequently the cost of goods and services, the Fed hopes that consumers will be less willing to spend money, decreasing demand and reducing the amount of cash floating through the system.
The current inflation rate is 7.9 percent, the highest it’s been in four decades. But Blanton said it will take some time for the Fed’s rate hikes to make a dent in it.
“There won’t be an immediate impact,” he said. “It has to filter through the system and it has to be meaningful enough to alter buying habits.”
Blanton said that the Fed’s rates have been artificially low for years, which has allowed consumers to make big purchases at historically low-interest rates. He expects the biggest differences will be seen in mortgage loan rates but he doesn’t predict a major change in credit card rates since most of them hadn’t decreased their rates when the Fed rate was lower.
