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Interest rates steer the economy
Why rates go up
In an expansion, spending keeps rising and so do prices. The increase in spending is fueled by credit, which can be created instantly out of thin air, and when spending and incomes grow faster than the production of goods, prices rise. That is inflation, and the central bank responds by raising interest rates.
How higher rates bite
Higher rates mean fewer people can afford to borrow, and the cost of existing debts goes up, like the monthly payments on a credit card rising. People borrow less and owe more each month, so they have less left to spend. Spending slows, incomes drop, and prices fall, which is deflation, and economic activity shrinks into a recession.
How the cycle restarts
If the recession becomes too severe and inflation is no longer a problem, the central bank lowers interest rates. Debt repayments shrink, borrowing and spending pick up, and another expansion begins. The cycle lasts about 5 to 8 years and repeats for decades, with spending limited only by the willingness of lenders and borrowers to provide and receive credit.
How do central banks set interest rates?
In the United States the Federal Reserve sets a target range for the federal funds rate, the rate banks charge each other for overnight loans. It steers that rate with tools such as the interest it pays on banks' reserve balances. Other borrowing costs, including mortgage and credit card rates, tend to follow the benchmark up or down.
The Fed's rate-setting committee holds eight scheduled meetings a year.
Why did Volcker push rates so high?
Paul Volcker became Fed chair in August 1979, when US inflation was running in double digits. The Fed pushed the federal funds rate to roughly 20 percent in 1981, and the economy fell into a deep recession, with unemployment reaching 10.8 percent in late 1982.
Consumer price inflation, which hit about 13.5 percent in 1980, dropped to around 3 percent by 1983.
Why do rate changes take so long to work?
Many loans carry fixed rates, so only new borrowing and refinancing feel a change right away, and businesses plan investments months ahead. Federal Reserve staff models typically place the peak effect on output a year or more after a rate move.
Milton Friedman argued in the early 1960s that monetary policy works with long and variable lags.
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