Rate hikes are coming: what does this mean for you?

Fed officials are expected to raise interest rates on Wednesday, beginning their first round of rate hikes since one that began in late 2015.

The fact that the Fed is finally moving away from zero shows confidence in the health of the job market. But the speed at which interest rates are expected to rise underscores concerns about the soaring cost of living.

Americans will experience this policy change through higher borrowing costs: it will no longer be incredibly cheap to take out mortgages or car loans. And the money that is in bank accounts will finally bring in something, but not much.

“Money won’t be free anymore,” said Joe Brusuelas, chief economist at RSM US.

When the pandemic hit, the Fed made borrowing almost free in an effort to encourage household and business spending. To further stimulate the Covid-ravaged economy, the US central bank 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 stave off a financial meltdown.

The Fed bailout worked. There was no financial crisis linked to Covid. Vaccines and massive congressional spending paved the way for a rapid recovery. But now the Fed faces another challenge: rising inflation. Here’s how higher rates will impact consumers.

Borrowing costs are rising

Today unemployment is very low but inflation is very high. The US economy no longer needs all this help from the Fed.

Every time the Fed raises rates, it becomes more expensive to borrow. This means higher interest charges for mortgages, home equity lines of credit, credit cards, student debt and car loans. Business loans will also become more expensive, for large and small businesses.

The most tangible way this is manifesting is in mortgages, where expectations of rate hikes have already driven rates higher.

Key measure of inflation hits double digits in February

The rate on a 30-year fixed-rate mortgage averaged 3.85% during the week ending March 10. While still cheap historically, it has risen sharply from less than 3% in November.

Higher mortgage rates will make it harder to pay house prices that have skyrocketed during Covid. But weaker demand could cool prices. The median price of an existing home sold in January climbed 15.4% year-over-year to $350,300.

But it will still be relatively cheap to borrow

None of this means that it will suddenly become expensive to finance purchases.

Investors are current price within a 90% chance the Fed will raise interest rates six times this year, by a quarter point each time.

If that happens, the midpoint of the fed funds rate would be at a relatively low 1.625%. Although this figure is up from 0.125% today, it remains historically low.

For context, the Fed raised rates to raised to 2.37% during the peak of the last rate hike cycle at the end of 2018. Prior to the Great Recession of 2007-2009, Fed rates hit 5.25%.

And in the 1980s, the Fed led by Paul Volcker raised interest rates to unprecedented levels to fight runaway inflation. At the peak in July 1981, the effective federal funds rate exceeded 22%. (Borrowing costs will no longer be near these levels and are hardly expected to rise as sharply.)

Nonetheless, the impact on borrowing costs over the next few months will largely depend on the speed of the Fed’s rate hikes. There’s still plenty of debate about that, although Chairman Jerome Powell said in January he thought there was “wiggle room” to raise rates without threatening the jobs market.

Good news for savers

The floor rates penalized savers.

Money hidden in savings, certificates of deposit (CDs) and money market accounts has yielded next to nothing during Covid (and for much of the last 14 years, for that matter). Compared to inflation, savers lost money.

The good news, however, is that these interest rates will rise as the Fed moves away from zero. Savers will start earning interest again.

But it takes time to play out. In many cases, especially with traditional accounts at large banks, the impact will not be felt overnight.

And even after several rate hikes, savings rates will remain very low, below inflation and expected stock market returns.

Markets will have to adapt

The Fed’s free money has been amazing for the stock market.

Zero percent interest rates drive down government bond rates, essentially forcing investors to bet on risky assets like stocks. (Wall Street even has a phrase for it: TINA, which means “there is no alternative.”)

The war has brought the world to the brink of a food crisis

Higher rates could also pose a challenge for the stock market, which has grown accustomed to – if not addicted to – easy money. Markets have already seen significant volatility amid concerns over the Fed’s plan to fight inflation. Last week, the Nasdaq fell in a bear market, signaling a 20% decline from previous highs.

But much will depend on how quickly the Fed raises interest rates – and how the underlying economy and corporate earnings perform afterward.

At a minimum, the rate hikes mean the stock market will face more competition going forward from boring government bonds.

Cooler inflation?

The objective of the Fed’s interest rate hikes is to control inflation, while preserving the recovery of the labor market.

Consumer prices rose 7.9% in February from a year earlier, the fastest pace since January 1982. Inflation is far from the Fed’s 2% target and has worsened in recent months.

Economists warn that inflation could worsen further in March as commodity prices have soared since Russia invaded Ukraine. Everything from food and energy to metals has become more expensive, although oil prices have retreated from recent highs.

And in recent days, China has suffered its worst outbreak of Covid-19 in two years, prompting the authorities to lock down key parts of the country. The lockdowns will add further strain to scrambled supply chains at the heart of inflation.

The high cost of living is causing financial headaches for millions of Americans and contributing significantly to declining consumer sentiment over the decade, not to mention President Joe Biden’s low approval ratings.

Still, it will take time for the Fed’s interest rate hikes to start reducing inflation. And even then, inflation will still be subject to developments in the war in Ukraine, the supply chain mess and, of course, Covid.

Borrowing costs are rising

But it will still be relatively cheap to borrow

Good news for savers

Markets will have to adapt

Cooler inflation?

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