How increasing interest rates could reduce inflation, but potentially cause a recession (2024)

FAQs

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

“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.

When inflation increases, central banks raise interest rates to slow the economy with the goal of bringing down inflation. With higher interest rates, the probability of a recession increases, leading to layoffs, fewer jobs, and decreased consumer and corporate spending, among other effects found in a slowing economy.

Raising the interest rate

This lowers spending in an economy, causing economic growth to slow. With more cash held in bank accounts and less being spent, money supply tightens and demand for goods drops. Lower demand for goods should make them cheaper, lowering inflation.

How can interest rates push a business cycle into a contraction? High interest rates can promote saving, which in turn can cause a downturn in demand, causing surplus products on the market.

The global economy runs on money, so when the cost of money in the form of interest rates rises rapidly, growth may slow sharply or even give way to a recession.

Inflation can cause a recession in some instances, such as: If inflation spurs consumers to cut spending too much. Less money in the economy means lower revenues and potentially negative growth for businesses. If the Fed raises interest rates too much to rein in inflation.

As corporations and households get overextended and face difficulties in meeting their debt obligations, they reduce investment and consumption, which in turn leads to a decrease in economic activity. Not all such credit booms end up in recessions, but when they do, these recessions are often more costly than others.

Monetary policy primarily involves changing interest rates to control inflation. Governments through fiscal policy, however, can assist in fighting inflation. Governments can reduce spending and increase taxes as a way to help reduce inflation.

The Fed has repeatedly raised rates in an effort to corral rampant inflation that has reached 40-year highs. Higher interest rates may help curb soaring prices, but they also increase the cost of borrowing for mortgages, personal loans and credit cards.

Inflation may occur due to increases in production costs associated with raw materials or labor. Higher demand can also lead to inflation. Certain fiscal and monetary policies such as tax cuts or lower interest rates are also potential drivers.

Are we in a recession in 2024? ›

Though the economy occasionally sputtered in 2022, it has certainly been resilient — and now, in the second quarter of 2024, the U.S. is still not currently in a recession, according to a traditional definition.

When interest rates are rising, both businesses and consumers will cut back on spending. This will cause earnings to fall and stock prices to drop. On the other hand, when interest rates have fallen significantly, consumers and businesses will increase spending, causing stock prices to rise.

Higher interest rates typically slow down the economy since it costs more for consumers and businesses to borrow money. But while higher interest rates can make it more expensive to borrow and could hamper overall economic growth, there are also some benefits.

Your money is safe in a bank, even during an economic decline like a recession. Up to $250,000 per depositor, per account ownership category, is protected by the FDIC or NCUA at a federally insured financial institution.

56% of Americans believe the U.S. is in a recession, according to a Harris poll of 2,119 adults conducted for the Guardian, an opinion far from the truth by pretty much any definition of a recession, as the U.S. economy has grown in seven consecutive quarters, with gross domestic product growing by 6.3% from 2022 to ...

Increasing the bank rate is like a lever for slowing down inflation. By raising it, people should, in theory, start to save more and borrow less, which will push down demand for goods and services and lead to lower prices.

Condition No. 1: Energy prices need to decline in order to reduce inflation and avoid a recession, according to Altig. Luckily, we are beginning to see a decline. As of early December, gas prices in the U.S. were lower than they were one year ago.

In short, the Fed's updated projections paint a hard-landing scenario suggesting the FOMC is willing to risk a recession in order to bring inflation down. The Fed certainly does not want a recession, but persistent inflation may have left the Fed no choice but to raise interest rates high enough to trigger one.

The cost of recessions in terms of wages and employment are more regressive. Inflation, however, is a form of income redistribution in the short run, but does not directly reduce incomes in the aggregate.

During inflationary periods, prices are higher, and it is more expensive to incur debt. For these two reasons, companies often sell fewer products and the economy slows.