Why do central banks raise interest rates?

Central banks are raising interest rates around the world due to escalating inflation. In the US, the Federal Reserve has jumped interest rates from 0% - 0.25% in 2020 to 1.50 - 1.75%, and monetary authorities indicate there will still be more this year.

But why do the Fed and other central banks raise interest rates? How does that affect the economy?

Each country's central bank, which generally works independently, is responsible for maintaining price stability in the economy, and in the U.S. this responsibility falls on the Federal Reserve. 

The effects of the Covid-19 pandemic and then the war in Ukraine drove inflation higher. It happens because when the economy booms, distortions such as inflation can occur, threatening the economy's stability. 

By raising the federal funds target rate, the Fed aims to increase the cost of credit across the economy, thereby cooling down the economy. In practice, higher interest means that credit is more expensive, as money costs are rising.

Businesses and consumers both end up paying more on interest when thoseinterest rates increase. As a result, high-interest rates discourage consumer spending, especially on financed goods such as cars and real estate. Households will reduce their spending as they save more, resulting in a drop in inflation. 

In times of high-interest rates, what should you do?

Interest rates affect borrowing costs, mortgages, pensions, and savings. The Federal Reserve's interest rate increase has a ripple effect throughout the economy, which means other rates will rise as well. 

In these moments, it's important to avoid loans and mortgages unless you cannot postpone them for a long time. If you need financing in the coming months, specialists recommend locking in the interest rate before it goes up, and make sure you pay off your credit cards on time as well. 

In response to the Fed's rate increase, Adjustable-Rate Mortgages (ARMs) are expected to raise their interest rates, but fixed-rate mortgages will not be affected by it.

In contrast, CDs and savings accounts are paying more for your money, with some savings accounts offering rates of 1.5%, up from 0.20 percent last year.

There are no positives in long-term high inflation, and the rise of interest rates also means slower economic growth, but it's a necessary measure to control inflation and maintain a healthy economy.