The Fed’s strategy: the basics

Wait… doesn’t raising rates mean higher prices, and worse inflation? Let me explain. In the most basic sense, inflation is caused by too many dollars chasing too few goods. But inflation can be complicated and rarely is it caused by a single factor. However, basic economics tells us that supply and demand dictate prices in a free market economy. Prices rise if demand increases, and supply drops or stays the same. If supply falls without a proportional decrease in demand, prices will also rise. Fortunately, families and companies saved a tremendous amount of money during the pandemic. Unfortunately, they’re now spending it.

Turning to the bond market, when interest rates rise, it becomes more costly to borrow money. Something that may pencil out at 3 percent may not make sense at 7 percent, whether it is buying a house or a company like PepsiCo building a new bottling plant in Yuma. If a family doesn’t buy a house, or Pepsi doesn’t build a new plant, it tends to dampen the economy a little, or a lot. And when prices of things like electricity or gasoline soak up more savings or income from people, this leaves consumers with less money in their pockets, and they spend less as a result. This might cause grocery shoppers to prefer the generic brand over the name brand or spend less on non-essentials. Or shift from butter to margarine. It also affects business spending, which is sensitive to the cost of money. So rising interest rates tends to dampen both individual consumer spending and business activity.

Rising interest rates are an attempt to bring the economy back into equilibrium. The expectation is that the prices of many items will fall, including everyday goods such as gas and groceries. However, the question is whether the Fed can walk this fine line of raising the interest without raising them too much, too quickly. This is sometimes referred to as a “soft landing.”

Meanwhile, borrowers suffer. They either pay higher rates, or don’t borrow at all. Or take a while to become accustomed to higher rates, but they still impact affordability. And lenders and MI companies and everyone associated with residential lending is impacted. Make sense?