How increasing interest rates could reduce inflation, but potentially cause a recession

Today's economy looks very different compared to last year's, and concerns about inflation, market downturns and even a potential recession are weighing on the minds of many Americans. In these uncertain times, it can be difficult to make sense of such an influx of bad news: Why might there be a recession? Wasn't inflation supposed to be transitory?

To help break it all down, Select spoke with economist Michael Gapen, managing director and head of U.S. economics research at Bank of America, about how increasing interest rates can help tamp down on inflation — and how doing so could result in a recession.

First off, inflation is defined as the rise in prices of goods and services in an economy. In July 2022, the inflation rate in the U.S., as measured by the Consumer Price Index, was 8.5%. That means the costs of goods rose by an average of 8.5% year-over-year. While not all goods and services were equally impacted by inflation, categories such as food and energy experienced the largest hikes.

The rise in prices across the board was caused by many different factors — the war in Ukraine led to a spike in energy prices, while supply chain shortages affected the prices of other goods, such as cars. In other words, high prices are being caused by having too little of a supply of goods and services and, at the same time, having too much of a demand for them.

That's where the Federal Reserve System comes in — its primary function is to maintain a low inflation rate and unemployment rate in the U.S., which it does by controlling interest rates, or the federal funds rate. By increasing the federal funds rate, the Fed makes it more expensive for banks, and therefore consumers and businesses, to borrow money.

For consumers, higher interest rates mean it's more expensive to buy big-ticket items that are typically purchased with credit, such as homes, automobiles, furniture and large appliances, says Gapen.

As a result of an interest rate hike, you may end up seeing a higher annual percentage rate, or APR, on your credit card or a higher annual percentage yield, or APY, on your savings account. That means that consumers who carry revolving debt on their credit card could see higher interest charges on their monthly statement. Those who currently have credit card debt may want to consider signing up for a card that offers a 0% APR introductory period on new purchases or balance transfers to help tide them over.

For example, the Wells Fargo Reflect® Card is a good no-annual-fee option that offers a 0% introductory APR for 21 months (after, 18.24%, 24.74%, or 29.99% variable APR) starting from the date of your account opening, for purchases as well as qualifying balance transfers. Balance transfers made within 120 days from account opening qualify for the intro rate, BT fee of 5%, min $5.

Another no-annual-fee card to consider is the U.S. Bank Visa® Platinum Card, which offers a 0% APR intro period for the first 18 billing cycles on balance transfers and purchases (after, 18.74% - 29.74% variable APR).

Consumers may also want to think about putting their money in a savings account that offers a higher APY — high yield savings accounts are a good choice as they pay out significantly more in interest than what you'd get from a traditional savings account. And as the Fed continues to raise interest rates, expect for the APY on your savings account to increase — meaning more money back in your pocket every month. Select ranked LendingClub High-Yield Savings and Marcus by Goldman Sachs High Yield Online Savings among the best high yield savings accounts.

Another potential result of higher interest rates: Businesses may pull back on borrowing and investing, which means consumers and businesses would start spending less and eventually bring demand back down to a level that's commensurate with supply.

"Raising interest rates helps to reduce the overall level of demand and therefore, hopefully, reduces the upward pressure on prices," says Gapen.

So why might this cause a recession? In the long run, businesses may respond to consumers purchasing fewer goods and services by reducing production, explains Gapen. Put another way: When people start buying less good and services, companies respond by producing less of them. According to Gapen, when companies reduce output, they also cut back on inputs and labor.

"If you're slowing demand, you're likely slowing hiring, and there may be layoffs, which could push the unemployment rate up," says Gapen. "Hopefully, what you're also doing is slowing the rate of inflation at the same time."

In other words, when the Fed increases interest rates, it reduces demand for goods and services, which could result in companies hiring less or laying off their workers and potentially lead to a much-feared recession. 

With more interest rate hikes forecasted for the coming year, Gapen predicts it'll take one to two quarters for consumers to respond with lower demand. It will, however, take longer for prices to go down.

While the Fed's actions are sure to have an impact on inflation, Gapen notes that consumers likely won't feel relief from higher prices until supply chain bottlenecks resolve or geopolitical issues in Ukraine are eased. Until then, consumers may be stuck paying more for gas, cars and just about everything else.

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