The Federal Reserve on Wednesday raised its benchmark interest rate by half a percentage point, or 0.5%, the biggest increase in more than two decades. This increase brings the so-called federal funds rate to a range of 0.75% to 1%.
The Fed’s efforts to tackle inflation, which has hit a four-decade high, is also expected to include selling billions of bonds on its balance sheet.
Here’s a look at why the Fed is raising rates and what it means for consumers, along with tips on how to navigate this time of economic change.
Why is the Fed raising interest rates?
The short answer is to stabilize the prices of goods and services that have been rising at a breakneck pace.
At Wednesday’s press conference, Fed Chairman Jerome Powell said, “The economy and the country have been through a lot over the past two years and have shown resilience. Bringing inflation down is essential if we are to have a prolonged period of good labor market conditions that benefit everyone.
The Fed has an inflation target of 2%, but inflation has run well above that level, said Andrew Jalil, associate professor of economics at Occidental College.
Although there are different measures to gauge the rate of inflation, the government’s consumer price index for March measured it at 8.5% over the previous 12 months – the highest rate in 40 years.
“In the economy, higher interest rates mean higher borrowing costs for businesses, businesses and households. These higher borrowing costs drive down consumer spending [and] business and corporate investment spending,” Jalil said. “It will lower the overall demand for goods and services.”
In turn, he added, this should ease inflationary pressures. However, he pointed out that prices were rising for reasons beyond the Fed’s control, such as pandemic-related supply chain disruptions and Russia’s war on Ukraine (which led to higher prices). food and energy costs).
Will the Fed achieve its goal?
Jalil said it is difficult to predict what will happen to the economy, especially given the external factors that are fueling inflation. But he thinks inflation will eventually hit the Fed’s 2% target as supply chain disruptions ease and the war in Ukraine hopefully ends.
“They have done an exceptional job of keeping inflation low and stable close to their target since the early 1980s,” Jalil said.
How will the hike affect consumers?
Financial analyst and writer Richard Barrington said inflation has already affected some lending rates regardless of Fed actions as lenders demand higher payments.
Barrington pointed out that the 30-year mortgage rate has risen about 2% since the start of 2022, while the Fed only raised rates by 25 basis points, or 0.25%, in March.
“It’s because the Fed is really lagging behind when it comes to dealing with the recent inflation spike,” Barrington said. “You’ve seen mortgage lenders, for example, take more decisive action before.”
Lenders don’t necessarily have to wait for the Fed to raise rates, he added. “They can’t afford to go that far behind inflation because it means the money they get back from a loan is worth less than it was when they loaned it out.”
Barrington said you’ll see direct impacts, however, with some credit cards, whose interest rates are tied directly to the federal funds rate.
The traditional, simplified logic around rising interest rates is that they are bad for borrowers, who pay higher costs for loans. But, and here’s the silver lining, they’re good for savers because their accounts will earn more interest.
However, we live in strange times. The average savings account interest rate has remained at just 0.06% for an entire year, according to the Federal Deposit Insurance Corp.
“Banks take care of themselves first. They were much quicker to raise the rates they charge consumers on loans than they were to raise the rates they pay consumers on savings accounts,” Barrington said. “It’s kind of a lose-lose situation.”
What advice do you have for consumers trying to navigate this period?
If you’re not able to pay off your balance each month, Barrington said, you should try harder than ever to cut back on your credit card spending.
“Now is a particularly good time to avoid paying interest on your credit cards, as it is getting more and more expensive,” he said.
He also pointed out that there has been an increase in the popularity of adjustable rate mortgages. But they should be avoided for now, he said, because you’re locked into a rate for a period of time and then the rate resets to current market levels.
“After this initial period of low rates, if rates adjust to market rates that have continued to rise, these borrowers would see their monthly payments increase,” Barrington said. “In a rising rate environment, it’s much safer to lock in a fixed rate, so you know what your payments will be.”
Barrington added that it’s important for consumers to seek out the best rates.
Are we really facing the threat of a recession?
Deutsche Bank, for example, predicted that “we will have a major recession” caused by the Federal Reserve’s tactics to reduce inflation, CNN reported.
“We consider it very likely that the Fed will have to apply the brakes even more firmly and that a deep recession will be necessary to bring inflation under control,” Deutsche Bank economists wrote in a report.
However, predictions differ and Jalil said it is impossible to know for sure. “I think it is possible that there will be a recession. But I think there is also a possibility that we avoid a recession,” he said.
At other times, when inflation reached relatively high levels in the United States, he said, the Fed raised rates, leading to recessions. But one of the reasons recession forecasts could be wrong is that current inflation isn’t the result of normal conditions creating gradual price increases – it’s the result of “weird shocks” to the economy, Jalil explained.
Again, these supply chain issues and Russia’s war on Ukraine.
“If the news becomes much more favorable on both fronts, some of the inflationary pressures could naturally ease,” he noted.
Jalil offered another explanation for why we may not encounter a recession: the Fed aims for a healthy balance between supply and demand.
“It’s possible they’re reaching some kind of Goldilocks moment, where they don’t raise interest rates too much and cause a recession or keep them too low and fuel inflation, but rather where they raise them just at the right level to get asks to refresh,” he said.
Jalil added that if there is a recession, he doesn’t think it will be as bad as others in recent memory.
“Any recession is painful. But it will probably be softer,” he said. “The Great Recession of 2007-09 was caused by a financial crisis. These are really hard to solve. The effects may persist for a long time.
In this case, Jalil said that if the Fed caused a recession, its policymakers would likely lower interest rates once inflation fell to their targets, which would likely help the economy recover fairly quickly.
Why is the Fed planning to reduce its balance sheet?
The Fed has a balance sheet of nearly $9 trillion, which it has increased since the financial crisis to help keep interest rates low and support the economy. It has scooped up $4.5 trillion in Treasuries and mortgage-backed bonds in the past two years alone in response to the downturn caused by the coronavirus pandemic.
The Fed announced at its March meeting that it plans to reduce its balance sheet by selling some of its bonds and provided more details on Wednesday. Starting June 1, the Fed will reduce its holdings by $47.5 billion per month and increase that amount to $95 billion after three months.
Coupled with the rise in interest rates, this strategy aims to cool the economy.
With the Fed selling these securities and increasing the supply in the market, borrowers will have to offer higher interest rates to find buyers. This will reduce demand for credit and dampen inflation, the theory goes.
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