The US central bank raised its key interest rate by three-quarters of a percentage point on Wednesday, the biggest increase since 1994.
This follows the Fed’s decision to raise interest rates by half a percentage point in May, the biggest increase in 22 years.
The fact that the Fed is moving unequivocally shows confidence in the health of the job market. But the speed at which interest rates are expected to rise underscores the country’s growing concern about the rising cost of living.
Americans will initially experience this policy shift through higher borrowing costs: Getting a mortgage or auto loan isn’t crazy cheap anymore. And the cash in the bank account will eventually earn something, though not much.
The Fed speeds up or slows down the economy by adjusting interest rates higher or lower. During the pandemic, the Fed allowed households and businesses to borrow almost free. To further boost the economy ravaged by Covid, the US central bank has also printed trillions of dollars through a program known as quantitative easing. And when credit markets froze in March 2020, the Fed rolled out emergency credit facilities to avoid a financial downturn.
The Fed bailout worked. There is no Covid financial crisis. Vaccines and massive spending from Congress paved the way for a swift recovery. However, its urgent actions – and their delayed elimination – also contribute to today’s overheated economy.
The risk is that the Fed abuses it, slowing the economy to the point of inadvertently triggering a recession that causes unemployment to rise.
Borrowing costs are increasing
Every time the Fed raises interest rates, it becomes more expensive to borrow. That means higher interest costs on mortgages, home equity lines of credit, credit cards, student debt, and auto loans. Business loans will also be more expensive, for businesses large and small.
The most tangible way this is happening is with mortgages, where rising interest rates have caused rates to rise and slowed sales.
How high will the rate be?
Investors are expecting the Fed to raise the top of its target range to at least 3.75% by year-end, up from 1% now.
For context, the Fed raised interest rates to 2.37% during the peak of the last rate hike cycle in late 2018. Before the 2007-2009 Great Recession, Fed rates were as high as 5 ,25%.
And in the 1980s, the Fed led by Paul Volcker raised interest rates to unprecedented levels to combat inflation. At its peak in July 1981, the Fed’s effective interest rate was at 22%. (Borrowing costs won’t be anywhere near that now, and there’s little expectation that they’ll rise as dramatically.)
However, the impact on borrowing costs in the coming months will depend primarily on the pace – yet to be determined – the pace at which the Fed raises interest rates.
Good news for savers
Bottoming rates have punished savers. Money held in savings, certificates of deposit (CDs) and money market accounts earned almost nothing during Covid (and throughout the past 14 years, for that matter). Measured against inflation, savers lost money.
However, the good news is that this savings rate will increase as the Fed adjusts rates higher. The savers will start earning interest again.
But this takes time to take effect. In many cases, especially with traditional accounts at big banks, the impact won’t be felt overnight.
And even after many rate hikes, the savings rate will still be very low – below inflation and expected returns on the stock market.
The market will have to correct
Free money from the Fed is a great thing for the stock market.
0% interest rates lower government bond yields, essentially forcing investors to bet on riskier assets like stocks. (Wall Street even has an expression for this: TINA, which stands for “no replacement.”)
At a minimum, raising interest rates means the stock market will face more competition in the future from boring government bonds.
Lower inflation?
The Fed’s rate hike objective is to keep inflation under control while keeping the job market intact.
Economists warn inflation could worsen even further as gas prices continue to hit record highs in recent days, exacerbating a spike that began after Russia’s invasion of Ukraine.
Everything from food to energy to metals is becoming more expensive.
However, it will take time for the Fed’s rate hikes to begin to move away from inflation. And even then, inflation will still depend on developments in the war in Ukraine, supply chain chaos and, of course, Covid.
CNN’s Kate Trafecante contributed to this report.
