Alexander Kurov, West Virginia University and Marketa Wolfe, Skidmore College

The Federal Reserve on Jan. 26, 2022, signaled plans to begin raising interest rates “soon” – possibly in March – in a bid to tamp down inflation before it poses a serious risk to the U.S. economy. A separate report released the next day showed the economy grew 6.9% in the fourth quarter of 2021. An interest rate hike would be the first time the central bank has increased its benchmark lending rate in over three years.

Lifting the borrowing costs consumers and businesses pay for loans has the effect of slowing economic activity, which in turn could curb inflation. But there are also concerns that it could put on the brakes too quickly. We asked Alexander Kurov, a finance professor at West Virginia University, and Marketa Wolfe, an economist at Skidmore College, to explain what the Fed is doing and what it means for you.

1. Why is the Fed raising interest rates?

Short-term interest rates in the U.S. are now essentially zero.

The Fed quickly cut rates to zero at the beginning of the COVID-19 crisis in March 2020 in an attempt to soften the blow of the sharp recession that began that month as the U.S. went into lockdown. As a reminder of how bad things were back then, over 40 million workers – a quarter of the American workforce – filed for unemployment in the first few months of the pandemic, a staggering number with no precedent in the job market.

Although the recession was short-lived – lasting only two months – and the economy has mostly recovered, the Fed has kept rates at rock bottom because many workers and businesses still need support as the pandemic continues to rage.

The big problem for the Fed now is that U.S. consumer prices have surged. For 10 months in a row, inflation has been above the Fed’s 2% target and reached an annual pace of about 7% in December. This is the highest rate of inflation recorded in the U.S. in the last 40 years. High inflation means the prices people pay for goods and services are continually going up – especially for basic items like meat and gasoline, as well as for manufactured goods like cars.

The Fed can ill afford to allow this to continue because if higher inflation becomes entrenched, it would damage the economy. And the longer it lasts, the harder – and more painful for consumers and businesses – it is going to be to bring it back to a more sustainable 2%.

So the Fed has to act quickly before it’s too late.

2. How does the Fed raise rates?

The Fed sets a target range for what is called the “federal funds rate.” This rate acts like a benchmark for all interest rates in the economy.

While the Fed’s statement didn’t specify a time when it plans to raise rates, Chair Jerome Powell said “the committee is of a mind to raise the federal funds rate at the March meeting, assuming that the conditions are appropriate for doing so. Analysts expect it to be a 0.25 percentage point increase. This would affect banks’ cost of borrowing, which in turn slowly filters throughout the economy as lenders charge more for loans on homes, cars, businesses, college tuition and anything else you might want to buy with debt. Banks would also gradually increase the interest they offer on deposits and savings accounts.

The Fed does not directly control all these other rates, and the exact path they will take is not completely predictable, but the overall trend will be up if the Fed keeps raising its target rate.

Markets expect the Fed to raise interest rates at least two more times in 2022.

3. What does that mean for consumers and businesses?

Put simply, higher interest rates mean borrowers would need to pay more for the loans they get.

If the Fed lifts interest rates this year by 0.75 percentage point, as expected, this would translate into about US$45,000 in additional interest payments on a 30-year, $300,000 mortgage.

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So if you want to borrow to start a business, pay for college, buy a car or do anything else, you should expect your borrowing costs to be higher later this year.

On the other hand, higher rates is good news for savers and investors, as their returns from activities like making deposits and buying bonds will go up.

4. And how will it affect the broader economy?

Higher interest rates would likely slow down business activity. While this can help reduce inflation, it also means lower economic growth.

The Fed always makes decisions based on what is happening in the economy and on how economic conditions are expected to change. And changes in the economy are often hard to predict.

The biggest unknown at this point is what will happen to inflation later this year. This is uncertain because inflation is driven by multiple factors, such as supply chain shortages and strong demand.

In addition, the labor force participation rate has still not recovered to pre-pandemic levels, and the economy is experiencing labor shortages, which could push wages and prices higher. If these COVID-19-related pressures don’t ease up soon, inflation could continue to stay high or continue to accelerate, which may force the Fed to increase interest rates faster than currently expected.

On the other hand, if economic or employment growth stalls, this will make it much harder for the Fed to raise rates without making things worse. The Fed will need to find the right balance between taming inflation and avoiding slowing down the economy too much.

Article updated to add GDP report and Powell comment.

Alexander Kurov, Professor of Finance and Fred T. Tattersall Research Chair in Finance, West Virginia University and Marketa Wolfe, Associate Professor of Economics, Skidmore College

This article is republished from The Conversation under a Creative Commons license. Read the original article.