Why the Fed Raises Interest Rates
When the economy is heating up and inflation is above the 2% target, the Federal Reserve combats it by raising interest rates. Higher interest rates do a few things. On one hand, people are encouraged to save their money since it has a greater potential to earn interest. And on the other hand, people are discouraged from spending on credit and taking out loans since the interest on debt is higher.
The Chain Reaction of Slowing the Economy
While these are good financial habits at an individual level, when everyone starts doing this at the same time, it slows down the economy.
This is because one person’s spending is another person’s income. If consumers cut back on spending, then businesses lose revenue. If businesses lose revenue, then they often respond by cutting jobs. If people lose their jobs then they can’t spend or pay off their debts. The spiral continues and if interest rates remain high for too long then a recession or even a depression can follow. Now this reduction of economic activity does in fact solve the inflation problem, but it comes at the cost of hurting the broader economy.
The Panic Attack Analogy
Here’s an analogy I thought of to describe this situation.
Imagine someone is having a panic attack. Their state of panic is similar to rising inflation. Naturally, we’d want to calm them down, just as we’d want to bring inflation under control. Now pretend the only tool at our disposal is a pillow to press down on their face until they pass out. This would most certainly stop the panic attack, but now the individual is passed out, which is hardly a better state to be in. In this analogy, that unconciousness represents the economy entering a recession or depression.
A System with Only One Tool
This might sound extreme, but it helps illustrate how our current approach to inflation works. When the economy is heating up and prices begin to rise, the standard remedy is to put the economy into a chokehold. It’s not neccesarily the Federal Reserve’s fault. They’ve only been given a single tool, a simple lever, to slow things down. This situation reflects what is known as “Maslow’s Hammer”, a cognitive bias summed up by the phrase, “If all you have is a hammer, then everything looks like a nail”.
A Pattern Worth Noticing
This idea isn’t just theoretical, it shows up in the data. If you look at the chart below, which tracks the federal funds rate from 1968 to 2025, you’ll notice a clear pattern. The shaded regions indicate recessions, and almost every one is preceded by a period of rising interest rates. It raises an uncomfortable question: do we manufacture our own recessions?
