In March 2022, US inflation was 8.5%. The Federal Reserve's rate was 0.20%. Over the next 16 months, the Fed raised rates eleven times. By June 2023, inflation was down to 3.0%.
Raising interest rates is the Fed's main tool against inflation. Here is how higher rates slow price rises, why it takes time and what 1980 and 2022 show about it.
How do higher interest rates bring inflation down? Higher rates make borrowing dearer and saving more rewarding. Households and companies spend less. With weaker demand, prices rise more slowly.
It works with a lag. In 2022, inflation kept rising for three months after the first rate rise, to a peak of 9.1% in June.
What matters is the real rate: the interest rate minus inflation. In 2023, it turned positive for the first time since 2019.
In 1980 and 1981, the Fed pushed its rate as high as 19.1% to break inflation of 14.8%.
How a rate rise reaches prices
The Fed sets a short-term rate: the federal funds rate, which banks charge each other overnight. We explain how in How the Fed Sets Rates. From there, it spreads through several channels:
Borrowing. Loan and mortgage rates rise. The average 30-year US mortgage rate went from 2.65% in January 2021 to 7.79% in October 2023. Buying homes, cars and equipment on credit costs more.
Saving. Cash and bonds pay more, so spending now becomes less attractive.
Asset prices. Bond and share prices tend to fall when rates rise. Households feel less wealthy. We show the bond maths in Bond Prices and Yields.
The dollar. Higher US rates tend to lift the dollar, which makes imports cheaper. We explain this in How Exchange Rates Work.
Expectations. If households and companies expect inflation to fall, pay and price rises tend to be smaller.
Together, these cool demand. When demand falls short of what the economy can supply, companies find it harder to raise prices.
The real interest rate since 1970
A rate of 5% means little if prices rise 8% a year. The real interest rate subtracts inflation from the interest rate. Here, we use the federal funds rate minus the 12-month change in the Consumer Price Index (CPI), the most quoted measure of inflation. We explain CPI in What Is CPI?
A negative real rate still encourages borrowing, because inflation shrinks the debt. A positive real rate makes borrowing costly even after inflation.
Source: FRED (FEDFUNDS, CPIAUCNS); YX Insights
The chart shows both lines since 1970. In most of the 1970s, inflation ran above the Fed Funds rate. From 1974 to 1979, the real rate was negative in two months out of three.
1980: rates above inflation
US inflation peaked at 14.8% in March 1980. The Fed's rate averaged 17.19% that month. It peaked at 19.1% in June 1981, when the real rate reached 9.5 points.
Inflation fell to 2.6% by June 1983. The cost was a deep recession. Unemployment reached 10.8% in November 1982.
2022 to 2024: a fast rise, then a wait
The Fed began raising rates in March 2022. Inflation did not turn at once:
Source: FRED (FEDFUNDS, CPIAUCNS); YX Insights
June 2022: inflation peaked at 9.1%, three months after the first rise.
September 2022: core inflation, which leaves out food and energy, peaked at 6.6%.
May 2023: the real rate turned positive, for the first time since October 2019.
June 2023: inflation was 3.0%.
August 2024: the real rate reached 2.8 points, its highest in this cycle.
This time, unemployment stayed low. It did not go above 4.2% from 2022 to 2024.
Why it takes time
Many prices are fixed for months or years. Many US mortgages carry a fixed rate for 30 years, so only new borrowers feel a rate rise straight away. Rents reset when leases end. Many wages and prices are reset only once or twice a year.
So the effect builds slowly. A rate rise can take a year or more to show fully in inflation.
Where things stand in 2026
Inflation rose again in 2026, from 2.4% in January to 4.2% in May, while oil prices jumped. It was 3.4% in August. The Fed raised its target range to 3.75% to 4% on 16 September 2026. In August, before that rise, the real rate was 0.2 points.
The Fed's next decision is on 28 October 2026. Markets price the odds of another rise through futures, which we explain in What Are Fed Funds Futures?
Higher rates bring inflation down by cooling demand. They work slowly and through many channels. The real rate, the interest rate minus inflation, shows how hard the brake is pressed.
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