How does raising the interest rate help inflation?

LOUISVILLE, Ky. (WAVE) - The Federal Reserve has instituted its largest interest rate hike in nearly 30 years. Interest rates increased by .75% as a way to slow inflation - and get the economy back on track.

But how exactly does raising the price we pay for things help fight inflation?

Andrew Butters, an Assistant Professor at the Kelley School of Business says its all about balancing out supply and demand.

Before we can explain how a rise in the interest rate will help curb inflation, we need to understand where the inflation is coming from. Simply put - demand is outracing supply.

“So if demand is sort of in excess of supply, then what tends to happen is pressure on prices tends to go up. So we’ve seen that now obviously for the last 18 months and what the fed is attempting to do here is sort of suppress demand a little bit,” Andrew Butters said.

The idea is that if someone is spending more on their mortgage or credit card payment, they won’t have as much money to spend on luxury good and items.

In theory that lowers demand, increases supply, and brings prices down.

“By that very construction, what they’re asking to do is basically is have the economy kind of slow down or basically sort of tamper down the growth in spending and investments and other types of economic activities,” Butters said.

It doesn’t just affect consumers. Businesses are impacted too.

“Businesses themselves might have to manage, in particular, maybe they might have to not be as aggressive when it comes to making investments or expanding their business because that cost of borrowing for them as well,” Andrew Butters said.

The risk with this kind of move is that if economy slows down too much, it could potentially push it into a recession.

“They’re doing everything they can to attempt to alleviate that upward pressure in inflation that is causing all of us to experience a deterioration when it comes to our disposable incomes.”

Federal Reserve Chairman Jerome Powell says more rate hikes are possible. It’s expected the reserve will raise interest rates by at least another .5% next month.

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