Rate Hikes increase cost of borrowing. Putting more money into the system, making the dollar worth less. Do I have that right? Rate Hikes work by assuming that Americans are smart with their money and will consume less but is this reasonable? It makes no sense to me yet every economists seems to agree.
EDIT: This was probably a bad ELI5. So I appreciate the responses, very helpful. Learning more now.
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No, you got it the wrong way around. Rate hikes increase the cost of borrowing, and this **decreases** the amount of money in the system, making the dollar worth more.
Rate hikes cause businesses and consumers to reduce spending because they are usually borrowing money (either short term or long term such as mortgages) and will need to make larger payments on those debts.
This is desired during a time of high inflation because a slow down in spending generally leads to inflation decreasing as demand falls back to roughly the same level as supply. The hard part of this process is raising the interest rates enough to cause just enough of a slow down in purchasing to bring inflation under control without the interest rates going high enough to push the economy into a recession. Because the people making the decisions on when to raise rates and how much to raise them are looking at data from the past (past month or past quarter) to determine the current rate of inflation, they tend to over-correct and end up raising the rates a little higher or faster than what was necessary to get inflation to where they want it to be.
Unfortunately you can’t get “real time” data on inflation because it would require the government to somehow collect information on every financial transaction as it happens and to process this data almost immediately to determine if prices went up (inflation) or went down (deflation, which can be worse in some ways than inflation) or basically stayed the same. There simply is no way to collect and process the necessary data that quickly.
The goal of the Fed and other central banks is not to get prices to go back down to where they were before inflation jumped up, but to get the prices stabilized and keep them from continuing to go up quickly. If prices start to drop (deflation) it would discourage investment and lead to businesses cutting staff (layoffs) to get their costs down to offset their dropping revenue. While you or I might like to see prices come down, having it happen on a large scale will likely trigger a recession as layoffs and dropping investment in new or updated businesses, facilities, etc. kicks in.
You got it wrong at the 2nd sentence. Increased cost of borrowing means money itself becomes more expensive so less money gets printed and dollar value stabilizes.
It doesn’t quite require for the average American to have an in-depth understanding of economics
Increased cost of borrowing means:
* Consumers are less inclined to borrow due to it being more expensive to borrow money. Conversely, 0% interest with no payback time-limit is basically free money
* Interest on current debts – including variable mortgages – eats into people’s disposable income. So people have less money, and also need to be more conservative with what they spend.
So raising rates organically reduces buying pressure.
A person would financially self-destruct if they were to continue borrowing or spending money as they were. But for the majority of the economy, they would spend less money on goods.
The reduced buying pressure means that businesses need to attract buyers, and their method is usually reducing prices. Also, businesses incur storage costs and fixed costs. Keeping prices high when there’s less demand isn’t sustainable.
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