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Inflation Slows Slightly as Fed Raises Rates Again. Everything You Need to Know

While inflation leveled off in April, it's not clear yet how the Fed's rate hikes will impact prices and the economy.

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New numbers from the Consumer Price Index hint that inflation may have hit its peak. Inflation reached a 40-year record high of 8.5% in March, but April data indicates that while inflation is still high at 8.3% year-over-year, it could be slowing down.

The news about inflation comes on the heels of the Federal Reserve's second rate hike of the year. To curb inflation, the Fed raised the federal funds rate rate on May 4 by 0.5 percentage point, the highest increase in 22 years. When the Fed first raised rates in March, it projected there could be as many as six rate hikes throughout the year.

"Inflation is much too high and we understand the hardship it is causing, and we're moving expeditiously to bring it back down," Jerome Powell, the chair of the Federal Reserve, said during a May 4 press conference (PDF). "We have both the tools we need and the resolve it will take to restore price stability on behalf of American families and businesses."

Raising interest rates is a key step for combatting rampant inflation, but it also means rate increases for credit cards, mortgages and other loans. With April's data indicating that inflation is starting to slow, what impact will the projected four additional rate hikes this year mean for the economy and your budget? 

Read on to learn how we got to this point with inflation, what the Fed is doing about it and what rising interest rates might mean for you.

How high is inflation today?

High inflation means your dollar has less purchasing power, making everything you buy more expensive even though you're likely not getting paid more. In fact, more Americans are living paycheck to paycheck, and wages are not keeping up with inflation rates.

Inflation surged in March, increasing 8.5% over the previous year and reaching its highest level since December 1981, according to the Bureau of Labor Statistics. Gas prices set record prices in March, rising more than 18% in that month alone. Grocery prices followed suit, hitting their highest increase since April 2020.

While gas prices dropped back down 6.1% in April, the overall effect on inflation was minimal, as it continued to rise 0.3% total for the month. In fact, "core inflation," which removes food and energy from the index, rose 0.6% in April, twice as much as its 0.3% rate for March.

Though the immediate impacts of COVID-19 on the US economy are easing, supply and demand imbalances persist and are one of the main contributors to higher prices. Russia's war on Ukraine -- which threatens political and economic stability worldwide -- is another key driver of skyrocketing gas prices. The cost of fuel has been so volatile that it accounted for nearly one-third of February's overall price increases.

How did inflation get so bad?

Essentially, we're here because of the pandemic.

In March 2020, the onset of COVID-19 caused the US economy to shut down. Millions of employees were laid off, many businesses had to close their doors and the global supply chain was abruptly put on pause. This caused the flow of goods shipped into the US to cease for at least two weeks, and in many cases, for months, according to Pete Earle, an economist at the American Institute for Economic Research.

But the reduction in supply was met with increased demand as Americans started purchasing durable goods to replace the services they used prior to the pandemic, said Josh Bivens, director of research at the Economic Policy Institute.

"The pandemic put distortions on both the demand and supply side of the US economy," Bivens said. "On the demand side, it channeled tons of spending into the narrow channel of durable goods. And then, of course, that's the sector that needs a healthy supply chain in order to deliver goods without inflationary pressures. We haven't had a healthy supply chain overwhelmingly because of COVID."

This increased demand combined with the supply chain kinks induced inflation, which has persisted since the 2021 reopening of the economy. 

That noted, inflation isn't inherently a good or bad thing. Moderate and steady inflation is actually important for a healthy economy: It promotes spending since rising prices encourage consumers to buy now, rather than later, keeping demand up. Inflation can become a problem when it rises over 2% (as measured by the Fed) and when it rises rapidly. That messes with healthy consumer spending and, in extreme cases, can derail price stability.

What is the Federal reserve doing about inflation?

With inflation hitting record highs, the Federal Reserve, the government body in charge of keeping inflation in check, has been under a great deal of pressure from policymakers and consumers to get the situation under control. One of the Fed's primary objectives is to promote price stability and maintain inflation at a rate of 2%. To counteract inflation's rampant growth, the Fed raised the federal funds rate by half of a percentage point this week.

The federal funds rate is the interest rate that banks charge each other for borrowing and lending, usually on an overnight basis. By raising this rate, the Fed effectively drives up interest rates in the US economy.  

Raising interest rates helps slow down the economy by making borrowing more expensive. In turn, consumers, investors and businesses pause on making investments, which leads to reduced economic demand and theoretically reels in prices. In short, this helps balance the supply and demand scales, one cause of inflation that was thrown out of whack by the pandemic.

The Fed, which calculates inflation differently than the CPI, estimated inflation was at 6.4% as of February. The typical Federal Open Market Committee member -- the Fed's policy-making body -- projects this number could decrease to 4.3% (PDF) by the end of the year, following a series of rate hikes.

What do rising interest rates mean for you?

Raising interest rates will make it more expensive for both businesses and consumers to take on loans. For the average consumer, that means buying a car or a home will get more expensive, since you'll pay more in interest. 

For the past two years, interest rates have been at historic lows, partially because the Fed slashed interest rates in 2020 to keep the US economy afloat in the face of lockdowns. Since then, the Fed has kept interest rates near zero, a move made only once before, during the financial crisis of 2008. Prior to the Fed's recent rate hike, interest rates had already started rising in 2022. For example, 30-year fixed mortgage rates, while still historically low, are returning to pre-pandemic levels

Increasing rates could make it more difficult to refinance your mortgage or student loans at lower interest rates. Moreover, the Fed hikes will drive up interest rates on credit cards, ratcheting up minimum payments as well.

Securities and crypto markets could also be negatively impacted by the Fed's decisions to raise rates. When interest rates go up, money is more expensive to borrow, leading to less liquidity in both the crypto and stock markets. Investor psychology can also cause markets to slide, as cautious investors may move their money out of stocks or crypto into more conservative investments.

On the flip side, rising interest rates could mean a slightly better return for your bank account. Interest rates on savings deposits are directly affected by the federal funds rate. Several banks have already increased annual percentage yields (APYs) on their savings accounts in the wake of the Fed's rate hikes.

Should you be worried about a recession?

While inflation is top of mind for many Americans, experts don't think hyperinflation is a concern. Hyperinflation refers to rapidly increasing, out-of-control inflation, roughly defined as 50% a month or 1,000% a year. Hyperinflation generally only occurs in the case of major disaster, war or unstable government, when people panic and start dumping currency en masse.

The Fed took initial steps to counteract inflation by reducing its bond-buying program by $15 billion monthly in November last year, a rate which was increased to $30 billion in order to accommodate potentially raising interest rates sooner than planned -- which is exactly what the Fed did in March and again earlier this week.

And though these recent rate hikes are expected to help bring down inflation, there's still a concern on the table, as another four rate hikes are expected this year. If the Fed overreacts by raising rates too high, that could spark an economic downturn, or worse, create a recession. 

Raising rates too quickly might reduce consumer demand too much and unduly stifle economic growth, potentially leading businesses to lay off workers or stop hiring. That could drive up unemployment, which would lead to another problem for the Fed, as it is also tasked with boosting employment. 

But with inflation persisting and threatening to become entrenched in the US economy, Powell acknowledged that the Fed will raise interest rates more aggressively if needed. "The Committee is determined to take the measures necessary to restore price stability," Powell said this week (PDF). "The American economy is very strong and well positioned to handle tighter monetary policy."

We'll keep you updated on the evolving economic situation as the Fed moves forward with more rate hikes this year.