Fed officials said Wednesday they are raising interest rates, beginning their first rate hike cycle since late 2015.
The fact that the Fed is finally moving away from zero is evidence of confidence in the health of the labor market. But the speed at which interest rates could rise highlights concerns about the skyrocketing cost of living.
Americans will experience this policy shift due to higher borrowing costs: it will no longer be insanely cheap to take out mortgages or car loans. And the money lying in bank accounts will finally bring at least some profit.
“Money will no longer be free,” said Joe Brusuelas, chief economist at RSM US.
When the pandemic hit, the Fed provided almost free loans to stimulate spending by households and businesses. To further stimulate the Covid-ravaged economy, the US central bank also printed trillions of dollars in a program known as quantitative easing. And when credit markets froze in March 2020, the Fed rolled out emergency credit lines to avoid financial collapse.
The Fed bailout worked. There was no Covid financial crisis. Vaccines and huge Congressional spending paved the way for a speedy recovery. But now the Fed must take on another challenge: rising inflation. Here’s how higher rates will affect consumers.
Loan prices are rising
Every time the Fed raises rates, borrowing becomes more expensive. This means higher interest rates on mortgages, lines of credit, credit cards, student debt and auto loans. Business loans will also become more expensive for large and small businesses.
This is most noticeable in mortgages, where expectations of higher rates have already led to higher rates.
But it will still be relatively cheap to borrow
None of this means that financing purchases will suddenly become expensive.
Federal Reserve Chairman Jerome Powell said the central bank is likely to raise interest rates six more times this year to bring the average federal funds rate to 1.9% by the end of the year.
Even though it stands at 0.125% today, it is still historically low.
However, the impact on borrowing costs in the coming months will depend mainly on the speed of the Fed’s rate hikes. There is still a lot of controversy about this, although chairman Jerome Powell said in January that he thought there was “a lot of room” for rate hikes without threatening the job market.
Good news for those who save
Extremely low rates penalized depositors.
Money tucked away in savings, certificates of deposit (CDs) and money market accounts has paid next to nothing during Covid (and, for that matter, for most of the last 14 years). Compared to inflation, savers lost money.
The good news, however, is that these interest rates will rise as the Fed moves away from zero. Depositors will start earning interest again.
But it takes time to play out. In many cases, especially when working with traditional accounts in large banks, the effect is not noticeable overnight.
And even after several rate hikes, savings rates will still be very low—below inflation and expected returns in the stock market.
Markets will have to adjust
The free money from the Fed was amazing for the stock market.
Zero interest rates lower government bond rates, effectively forcing investors to bet on risky assets like stocks. (Wall Street even has an expression for it: TINA, which means “no alternative”.)
At a minimum, the rate hike means the stock market will face increased competition from boring government bonds.
The goal of the Fed’s interest rate hike is to bring inflation under control while preserving the labor market recovery.
Consumer prices rose 7.9% in February year-over-year, the fastest pace since January 1982. Inflation has not come close to the Fed’s 2% target and has worsened in recent months.
The high cost of living is causing financial headaches for millions of Americans and contributes greatly to a decade-long low in consumer sentiment, not to mention President Joe Biden’s low approval rating.
However, it will take time for the Fed’s interest rate hike to start reducing inflation. And even then, inflation will still depend on developments in Ukraine, the mess in the supply chain, and, of course, Covid.