Why does the Fed raise interest rates? And how do those hikes slow inflation?

  • Higher interest rates make borrowing more expensive for shoppers and companies, cooling demand with the aim of curbing inflation.
  • The Fed has raised rates five times this year.
  • The central bank is expected to hike rates for a sixth time on Wednesday by a big amount: 0.75 percentage point.

The cost of almost everything continues to rise at a blistering pace. 

While overall annual inflation slowed in September, it remained high at 8.2%, near a 40-year record. More alarming, the so-called core rate that excludes the volatile energy and food sectors accelerated, rising 6.6% for the largest 12-month increase in that index since August 1982 and demonstrating how widespread inflation has become.

To cool inflation, the Federal Reserve is expected to raise its benchmark short-term federal funds rate at the end of its two-day policy meeting on Wednesday  by 0.75 percentage point to bump the fedfunds target range to 3.75% to 4.0%.  That  would be the Fed's sixth straight rate hike and the fourth consecutive one by that amount. The first time it increased rates by 0.75% was in June, which was at that time, the largest increase at a single meeting since 1994.

But why are hikes used to combat inflation, and how do they work? 

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WASHINGTON, DC - JULY 27: U.S. Federal Reserve Board Chairman Jerome Powell pauses during a news conference following a meeting of the Federal Open Market Committee (FOMC) at the headquarters of the Federal Reserve, July 27, 2022 in Washington, DC. Powell announced that the Federal Reserve is raising interest rates by three-quarters of a percentage point. (Photo by Drew Angerer/Getty Images) ORG XMIT: 775845047 ORIG FILE ID: 1242147034

When will the Fed announce the next rate hike?

The Fed is expected to announce a 0.75% increase in its fed funds rate on Wednesday at 2 p.m. ET. Another rate hike is also expected at its final meeting of the year in December, but economists are split on the size of it.

The Fed's economic projections released in September showed the median fed funds rate at 4.4% by year end and up to 4.6% next year. If the Fed raises its fed funds rate by 0.75% on Wednesday, the target range will be 3.75% to 4%.

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How does a Fed hike work? How does it affect prime rate, 10-year Treasury bond? 

As the country’s central bank, the Fed is in charge of monetary policy, meaning it sets interest rates and money supply. Its dual mandate is to promote “maximum employment and stable prices in the U.S. economy.” Stable prices mean keeping inflation in check, with a long-term mean annual target of 2%. 

In 2020, CPI inflation was 1.4%. In 2021, it was 7%.

One of the Fed's main tools to control inflation is the fed funds rate, which is the rate banks charge each other for overnight loans. If that rate rises, banks may pass on their additional cost.

So although the Fed doesn't directly control all interest rates, when it raises the fed funds rate, most other interest rates eventually follow suit, including adjustable-rate mortgages, credit cards, home equity lines of credit, and other loans. Some of these are tied to the prime rate, which is based on the federal funds rate, according to 

Borrowing money then becomes more expensive for consumers, who in turn spend less. Demand begins to wane and inflation, in theory, starts to relent. 

Meanwhile, some Americans see their coffers buoyed by higher bank savings rates. 

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Does a Fed rate hike mean mortgage rates rise?

Yes, usually.

A Fed rate hike doesn't directly affect other interest rates but trickles out to other rates.

"It’s like throwing a pebble on a pond," the St. Louis Fed explains on its website. "It creates ripple effects that diminish farther away from the center." 

Short-term rates like those on short-term Treasury bills and securities and private short-term money market funds are among those most closely tied to the federal funds rate.

Credit cards, home equity lines of credit, adjustable-rate mortgages and auto loans are further out from the center of the ripple. 

When the Fed raises the fed funds rate, the prime rate -- the rate banks charge its best customers and companies -- follows suit. All sorts of consumer rates, including mortgage rates, are based on the prime rate.

How many times has the Fed raised interest rates in 2022? 

The Fed has raised interest rates five times this year. The pandemic’s shutdown of the economy had kept rates near zero before the Fed increased rates by a 0.25 percentage point in March, the first hike in more than three years. 

An additional increase of 0.50 percentage point came in May,  ]followed by a historic 0.75 percentage point bump in June, another 0.75 jump in July, and the latest three-quarters of a point one in September, putting the rate at its current range of 3% to 3.25%. 

How much will the Fed raise rates? 

Economists surveyed by Bloomberg predict the Fed will raise the fed funds rate by 0.75% for a fourth consecutive time on Wednesday.  The Fed's median economic projections show the fed funds rate reaching 4.4% by year-end and 4.6% next year, but many economists, including at Deutsche Bank, expect the fed funds rate will have to rise at least to 5%.

Are interest rate hikes good for stocks?

Interest rate hikes create volatility in the stock market. The value of future earnings tends to dip when higher interest rates are expected, according to U.S. Bank, making investors less eager to bid up stock prices.

Tech and small-cap stocks tend to rely more on borrowing to fuel their growth, so they'll usually be among those to be hurt first by rising rates.

Higher interest rates also are meant to slow the economy, which can stunt revenues and earnings for companies, potentially damaging their growth and stock prices. 

Contributing: Paul Davidson, Medora Lee