Raising Interest Rates

Fed is raising the interest rates as part of its escalating campaign to battle stubbornly high inflation.

CPI data in the past two decades

Why Does Inflation Happen

Inflation is a loss of purchasing power over time: It means your dollar will not go as far tomorrow as it did today. Inflation is usually measured as the annual change in prices for a basketball of goods. For example, Consumer Price Index (CPI) measures the cost of things urban customers buy out of pocket.

The reason for the inflation we currently suffer from is partly due to supply and partly demand.

• From the supply side, COVID-19 has shut down a lot of factories in the US and China, and has clogged shipping routes. The war between Ukraine and Russia (important export countries in steel, oil) only makes matters worse.
• From the demand side, the Quantitative Easing (QE) policy in 2020-2021 (including the covid-relief package by the US) ****and low-interest rate make holding cash and saving less attractive since both of them provide basically no yield. Therefore, people increase their spending & investment alternatively.

From Economics 101, we learned that increase in demand + decrease in supply = rise in price, in the broadest sense that’s how inflation comes into play.

Why Inflation Is A Problem

Most of the time, steady inflation is a good thing to have in any country’s economy, since it is oftentime deemed a by-product of the booming economy. When the economy is flourishing, with low unemployment rate and higher production power, people tend to have higher buying power generally, and a steady inflation would not be noticed.

However, when inflation becomes higher, it can has several negative effects:

• Erodes Purchasing Power
  • When inflation is high the purchasing power of 1 dollar is decreasing faster each year, compounding effect makes it worse

• Hurts the Poor Disproportionately
  • The poor spend the largest percentage of their income on necessities, so inflation has a larger effect on them than the upper class
• Wage-price Spiral
  • When inflation is high and accelerating, workers expect future inflation to keep rising and thus demand higher wages. Rising wages can increase disposable income and thus push the price higher, creating a conceptual spiral.

Why Raising Interest Rate Can Theoretically Curb Inflation