Why is the interest rate going up?

Interest Rate Hike : Why is the interest rate going up?

The Fed raised interest rates by the most in over 20 years when it raised interest rates by half a percentage point this past Wednesday. In an effort to cool off demand and lower inflation. Unfortunately, consumer prices have been rising at the fastest pace in 40 years.

Let’s take a look at 4 years ago, when the last raised rates before Covid:

On June 14th of 2018, the federal reserve increased the interest rate by .25 percent, specifically from 1.75 to 2.00. This decision had potentially positive and negative effects on the economy as well as individuals. 2018 was only ten years after the beginning of the Great Recession in 2008. So the economy was resurrecting its growth and declining unemployment rate. Overall, the most likely explanation for this increase in interest rate is the Federal Reserve’s effort to fight the rising inflation rate due to the growing economy. 

Since the Great Recession ended in 2009, the United States economy had been growing steadily and entered an expansionary gap in 2018.

This expansion is shown through the decreasing unemployment rate. Where more people start becoming involved in the workforce and contributing to the economy (Figure 1). Naturally, people are increasing their income, savings and likely their consumption.

The Government further incentivized consumption and economic growth through increased government spending and tax cuts (Tankersley and Irwin, 2018). Expectedly, these factors increased the demand for goods and services, causing an outward shift in aggregate demand curve, when looking at the AS/AD model. Additionally, this decrease in unemployment created a higher labor force and therefore, an increase in production output and GDP.

A decrease in tax makes production cheaper.

Allowing producers to increase output, and causing the aggregate supply curve to shift upward in the AS/AD model. This outward shift in demand combined with an upward shift in supply leads to a new and heightened short run equilibrium. Where both production and inflation are above their respective long run levels. Overall, this increase in inflation and production proves the economy to be in an economic expansionary period in 2018. 

Although an increase in inflation causes the prices of goods and services to rise, consumers in 2018 were willing to meet these prices because of their increased income and incentivised propensity to consume. A higher rate of inflation is normal in periods of economic expansion, but policy makers must avoid an inflation spike. Where prices get too high for consumers to pay. And causes the economy to decline (Tankersley and Irwin, 2018). In 2018, the inflation rate was between 2.1% and 2.2%, which is significantly greater than the target rate of 2%, leading to the Fed’s decision to increase interest rate (Figure 2).

The Great Depression & The Federal Reserve

The Monetary Policy Reaction Function (MPRF) is a policy tool that shows the recommended action in response to the economic conditions of inflation. In the MPRF, interest rate rises with inflation rate, meaning that an increase in interest rate causes consumers to spend less leading to a decrease in inflation. The Fed’s increase in interest rate is simply moving along the MPRF, as there is no shift in the MPRF graph because the target rate of inflation is unchanging at 2%. 

In this decision, there are both upsides and downsides to the directionality and timing of changing the interest rate.

Federal intervention becomes needed to prevent a spike and subsequent collapse; without raising interest rates to match the inflation within the economy, there is potential for prices to climb so high that demand halts altogether, potentially causing the economy to plunge back into a recession (Tankersley and Irwin, 2018). Increasing interest rates means that the cost of borrowing money also increases, causing people to have a decreased demand for loans and subsequent consumption.

Additionally, higher interest rates incentivize holding money in savings accounts.

Further decreasing immediate demand for goods and services (Bayly, 2018). This decrease in demand brings down inflated prices. And slows the growth of the economy in a way that is steady and controlled. Overall, raising interest rates has many beneficial and preventative effects. 

While interest rates can control inflation in a very beneficial and protective way for the economy. There are also factors to consider that may be detrimental. The timing of implementing an increased interest rate is very important, as halting economic growth too early prevents many potential benefits of growth. With heightened supply, demand, and growth in the labor market, job wages are also expected to increase.

However, if the Fed raises interest rates before the economic expansion has translated into increased wages, the decline in demand will have an adverse effect on the job market because employees will be less inclined to hold their jobs (Tankersley and Irwin, 2018).

Another disadvantage of increasing interest rates is that individuals that had taken out adjustable-rate loans or are in credit card debt. Will be required to pay more back than they had expected. As a result, putting them in a financial situation, not benefited by stumped growth (Bayly, 2018). Overall, raising interest rates could be detrimental to economic growth and individuals. 

While there were clearly many factors to consider in the decision to raise the interest rate, the correct decision has many beneficial implications for the economy as a whole:

Based on the circumstances before and after, increasing the interest rate by 25% on June 14, 2018 was a good decision. The economy had been in an increasing expansionary gap after the recession in 2008. And the inflation rate started to reach its highest levels in the past three years. So federal intervention became warranted (Figure 2).

After the implication of a higher interest rate, the inflation rate began to decline.

And remained low in the following years, without increasing above 2% again until after the 2020 Pandemic (2020). Additionally, the decreasing unemployment rate after 2009 became unaffected by the increased interest rate. As the decline remained almost linear (Figure 1). This shows that the economy remained in an expansionary gap and the Fed accomplished the goal of fostering economic growth while dampening the threat of another recession. 

Figure 1. Unemployment rate in the United States (in percentage) mapped over a 15 year period. Recessions, shown highlighted in gray. 

Figure 2. Inflation rate in the United States mapped over a 5 year period. Recessions, highlighted in gray. 

Written by Lauren Kauppila

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Interest Rate Hike : Why is the interest rate going up? References 

Tankersley, J., Irwin, N. (2018, June 13). Fed Raises Interest Rates and Signals 2 More Increases Are Coming. The New York Times. https://www.nytimes.com/2018/06/13/us/politics/federal-reserve-raises-interest-rates.html 

Bayly, L. (2018, March 21). New Fed head approves first rate hike of 2018. NBC News. https://www.nbcnews.com/business/economy/new-fed-head-approves-first-rate-hike-2018-n858726 

Interest Rate Hike : Why is the interest rate going up?