What happens when Fed increases interest rates?

If everything goes according to plan – the US Federal Reserve will hike interest rates for the first time in three years. The last time the US Federal Reserve hiked interest rates was back in December 2018. Since then, slowing economic growth and the pandemic forced the world’s largest central bank to drive rates back down to zero.

With things slowly heading back to normalcy, the Fed now wants to reverse back to the more borrow and lend their excess reserves to each other overnight. Currently, the Federal Funds Rate is 0% to 0.25%. This means that if banks lend their excess cash to other institutions from their reserves, they will charge a rate of interest within this range.

Why Are Interest Rates Cut Or Hiked?

In an economic slowdown, the central bank cuts interest rates to boost economic activity and growth. The intention is to reduce the cost of borrowing so that people and companies are more willing to invest and spend. With reduced borrowing costs, businesses take more loans, hire more people and expand production. The logic works in reverse when the economy is hot and booming.

What Happens When The Fed Raises Rates?

The main reason why the Federal Reserve increases interest rates is to increase the cost of credit throughout the economy. 

As financial institutions themselves have to pay a price for borrowing money, an interest rate hike means it will cost them more to borrow the same amount. To cover for that, they will increase the rates at which they lend money to their customers. As the cost of borrowing rises, a customer will have to pay more to repay his debt, thereby reducing his purchasing power. Higher expenses would mean less disposable income in the hands of the customers, thereby reducing the revenue and profits of corporations.

Let’s simplify this with the help of an example:

Assuming that a bank has offered a loan worth $500K to an individual for a period of 30 years. As of date, the rate of interest for a 30-year fixed-rate loan stands at 3.75%. At the end of 30 years, the individual would have paid a sum of $833K, with $333K counting as interest. Calculating it on a monthly basis, the payment comes to around $2.3K per month.

Now, if the US Federal Reserve raised interest rates by 1% before the individual took the loan, the interest rate would rise to 4.75%. As a result of that 1% increase, the same individual will now have to repay $938K, of which $438K would be interest payment. The monthly EMI would also rise to $2.6K from the previous $2.3K.

In case such an event of higher interest rates occurs, the individual or the family would delay making the purchase they had planned or opt for a smaller loan amount to minimize their monthly installment.

Aside from loans, the Fed increasing interest rates also impacts stocks, bonds, credit card repayments, and many other facets of the economy.

Impact On Stock Market

Back in 2013, when the US Federal Reserve announced financial tightening, it resulted in enormous capital outflows from many emerging markets, including India. Equity markets across the world were roiled, and the event came to be regarded as the “taper tantrum.” Indian equities saw portfolio outflows worth $13B in just three months, between June to August 2013. The Indian Rupee depreciated by as much as 15% during that period, forcing the Reserve Bank of India to raise interest rates to stem the outflow.

Impact On Bonds

Bond prices and interest rates have an inverse relationship. As interest rates rise, bond prices fall. The longer the bond’s maturity, the more it is likely to fluctuate per the change in interest rate. Once interest rates begin to rise, newly issued securities by the government have a corresponding increase in rates. Treasury Bills and Bonds then come to be seen as safer bets as the risk-free return rate goes higher. As a result, investors move money out of other avenues as other assets become less attractive in terms of yield differential.

Impact On Savings Accounts

Higher interest rates may not be the best news for borrowers, but there cannot be better news for savings account holders. That’s because the Federal Funds Rate is also a benchmark for deposit account annual percentage yields – meaning the total interest one earns on savings bank deposits. Higher rates would mean that the interest earned on the savings account, deposit certificates, and money market accounts also rise.

The Fed hasn’t begun to raise rates yet, but it certainly is on course to do so. With inflation being at the highest in 40 years, a rate hike (s) should come as no surprise.

Did you buy a home in 2020? Did you job-hop in 2021? Are you holding off on buying a new car? Is a lack of affordable housing squeezing you out of the homebuying process?

Believe it or not, one institution stands behind even the tiniest of your financial decisions: The Federal Reserve.

What is the Federal Reserve?

The Federal Reserve is the central bank of the U.S., one of the most complex institutions in the world. The Fed is best known as the orchestrator of the world’s largest economy, determining how much it costs businesses and consumers to borrow money. Cheap borrowing costs can be the difference between businesses choosing to hire new workers or make new investments. Expensive rates, however, can cause both businesses and consumers to pull back on big-ticket purchases.

“Your job security, your portfolio, your debts and the direction of the economy are all subject to the Fed’s influence,” says Greg McBride, CFA, Bankrate chief financial analyst. “As that price of money changes, it ripples out in a lot of different directions. It impacts the health of the job market, the amount of money that’s flowing in the economy and the prices of assets at the household level.”

Here are the five main ways the Fed impacts your money, from your savings and investments, to your buying power and your job security.

1. The Fed’s decisions influence where banks and other lenders set interest rates

Higher Fed interest rates translate to more expensive borrowing costs to finance everything from a car and a home to your purchases on a credit card. That’s because key borrowing rate benchmarks that influence some of the most popular loan products — the prime rate and the Secured Overnight Financing Rate, or SOFR — follow the Fed’s moves in lockstep.

When interest rates are higher, the availability of money in the financial system also tends to shrink, another factor making it more expensive to borrow. Sometimes, rates even rise on the mere expectation the Fed is going to hike rates.

Case in point, here’s how much more expensive it’s gotten to finance various big-ticket items this year, after 2.25 percentage points worth of tightening from the Fed:

Source: Bankrate national survey data

After oscillating between 5.9 percent and 5.55 percent through the summer of 2022, the average 30-year fixed-rate mortgage officially barreled past 6 percent in the week that ended on Sept. 7, where they haven’t been since 2008. The more than 3 percentage point jump in a single year is unprecedented, McBride says.

Credit card rates, meanwhile, jumped beyond 18 percent that week for the first time since 1996.

Consumers often see higher rates reflected in one to two billing cycles — but only if they have a variable-rate loan. If you pay off your credit card balance in full each month, higher interest rates won’t impact you.

Rates, however, climb at an even faster rate for borrowers perceived to be riskier, based on their credit history and score. Conversely, some lenders might offer better deals than others, simply to attract more customers in a competitive market.

“Borrowing costs tend to increase first after a Fed rate hike,” says Liz Ewing, chief financial officer of Marcus by Goldman Sachs. “Banks are not required to line up their interest rates with the Fed’s rate, so each bank will respond to the Fed’s rate announcement and adjust rates in their own way.”

And while mortgage rates generally follow the Fed, they can often — and quickly — become disjointed. Mortgage rates mainly track the 10-year Treasury yield, which is guided by the same macroeconomic forces. But at its most basic level, those yields rise and fall due to investor demand.

Investors might pour more money into those safe-haven investments when the economy is expected to slow or contract, meaning mortgage rates might fall even if the Fed is raising interest rates. Longer-term yields, and consequently, mortgage rates, might also drop when the Fed is deep in the middle of an asset-purchase plan to lower longer-term rates, effectively making the U.S. central bank the biggest buyer in the marketplace.

2. The Fed’s rate acts as a lever for yields on savings accounts and certificates of deposit (CDs)

You might not be able to borrow as cheaply as you used to before a Fed rate hike, but higher interest rates do have some silver linings, especially for savers: As banks turn more to consumer deposits to fund loans, they ultimately end up increasing yields to attract more cash.

The caveat, however, is yields hardly ever rise as fast or as high as the Fed’s interest rate. Traditional brick-and-mortar banks also hardly need the deposits, especially today.

The average savings yield has risen 0.07 percentage points over the past year, rising from 0.06 percent to 0.13 percent as of the week that ended on Sept. 14, according to national Bankrate data.

Meanwhile, a 5-year certificate of deposit (CD) was paying an average 0.28 percent yield one year ago. Today, it’s offering an average of 0.83 percent.

But there are places where higher yields can be found, a search that’s becoming even more important for consumers amid high inflation. Those yields are at online banks, which are able to offer more competitive interest rates because they don’t have to fund the overhead costs that depository institutions with physical branches have.

A big example: The 14 banks ranked for Bankrate’s best high-yield savings accounts in July 2021 were offering an average yield of 0.51 percent, with a high of 0.55 percent and a low of 0.40 percent. At the time, that was about nine times the national average.

As of Sept. 16, however, the 11 banks ranked for Bankrate’s best high-yield savings accounts for September 2022 are offering an average yield of 2.22 percent, ranging from a high of 2.61 percent to a low of 2.05 percent.

“Retail savings rates often move a bit slower in a rising rate environment, but can also fall slower in a declining rate environment,” Marcus’ Ewing says. “Customers who have high-yield savings products could be getting good value in the long run.”

3. High interest rates could weigh on your portfolio or retirement accounts

Cheap borrowing rates often bode well for investments because they incentivize risk-taking among investors trying to compensate for lackluster returns from bonds, fixed income and CDs.

On the other hand, markets have been known to choke on the prospect of higher rates. Part of that is by design: Essentially, the U.S. central bank zaps liquidity from the markets when it raises rates, leading to volatility as investors reshuffle their portfolios.

It’s also because of worries: When rates rise, market participants often become concerned that the Fed could get too aggressive, slowing down growth too much and perhaps tipping the economy into a recession. Those concerns have battered stocks this year, with the S&P 500 down 18 percent to start the year, posting the worst first-half of a year since 1970.

For those reasons, it’s important to keep a long-term mindset, avoid making any knee-jerk reactions and maintain your regular contributions to your retirement account. When the Fed raises rates, that’s mostly to make sure the financial system doesn’t derail itself by growing too fast.

“Low rates are like candy to investors and keeping rates low is like asking the Cookie Monster if there should be more cookies,” McBride says. “Mom-and-pop investors should focus on the bigger picture: An economy that’s growing is conducive to an environment where companies will grow their earnings, and ultimately, a growing economy and higher corporate earnings are good for stock prices. It just might not be a smooth road between here and there.”

4. The Fed is one of the main influences of your purchasing power

The Fed’s interest rate decisions are bigger than just influencing the price you pay to borrow money and the amount you’re paid to save. All of those factors have a prevalent influence on the economy — and for consumers, that also means their purchasing power.

Too-low interest rates intended to stimulate the economy and juice up the job market can fuel demand so much that supply can’t keep up — exactly what happened in the aftermath of the coronavirus pandemic. All of that can lead to inflation.

But higher Fed interest rates is the fastest way to weigh on those price increases, though it’s important to point out consumers won’t immediately feel an impact. Cooling gas prices took the edge off of headline inflation in August, but grocery prices climbed by the fastest since March 1979. Meanwhile, a separate measure excluding the volatile food and energy categories picked up in August, suggesting price pressures are broadening out beyond supply chain-raddled industries.

Higher mortgage rates, for example, cools demand for housing over time, which also ultimately weighs on home values. Consumers and businesses might also start to delay other investments or purchases, now that the macro environment isn’t on their side.

5. How secure you feel in your job or how strong the job market is all relate the Fed

One of the biggest corners of the economy impacted by higher interest rates is the job market. Expansions that seemed like a wise idea when money was cheap might be put on the backburner. New opportunities made possible by low interest rates are no longer on the table. That has implications for more than just businesses. Individuals seeing opportunities get cut might start to feel insecure in their position; instead of job hopping to a new company, they might decide to just stay put and wait it out.

All of those moving parts are apparent now. Big tech firms from Apple to Google have announced that they’re slowing hiring plans. Other companies are pulling internship offers. Job openings as of August were still near a record high, but real-time data from job posting site Indeed shows they’re starting to cool.

Pulling back on the number of job openings, however, is different from outright cutting jobs — though cracks are starting to show there, too. The number of Americans applying for unemployment insurance has increased by nearly 31 percent since the Fed’s first rate hike in March, according to the Department of Labor.

Raising interest rates is a blunt instrument, with no method of fine-tuning specific corners of the economy. It simply works by slowing demand overall — but the risk is that the U.S. central bank could do too much. Put in the mix that officials are trying to judge how rates are impacting the economy with backward-looking data, and the picture looks even darker.

Eight of the Fed’s past nine tightening cycles have ended in a recession, according to an analysis from Roberto Perli, head of global policy at Piper Sandler.

Bottom line

There’s a common mantra when it comes to the Fed: Don’t fight it. Most of the time, it means investors should adjust their decisions along with monetary policy.

Consumers, however, might want to take the opposite approach. A rising-rate environment makes prudent financial steps all the more important, especially having an ample amount of cash you can turn to in an emergency or taking a long-term perspective.

Boosting your credit score, paying off high-cost debt or refinancing into a lower rate can also create more breathing room in your budget in a rising-rate environment. Use Bankrate’s tools to find the best auto loan or mortgage for you, and shop around for the best savings account to park your cash.

“You need an emergency fund regardless of where interest rates and inflation are,” McBride says. “You can’t afford to take risks with that money. That’ll stabilize your financial foundation, in the event that tougher economic days lie ahead.”

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