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
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.
But it will still be relatively cheap to borrow
None of this means that it will suddenly become expensive to finance purchases.
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.
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.”)
At a minimum, the rate hikes mean the stock market will face more competition going forward from boring government bonds.
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.
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.