What Happens When the Federal Reserve Increases Interest Rates

The Federal Reserve’s role is to maintain a stable U.S. economy – not too hot, not too cold, but just right. When the economy is booming and becomes overheated, issues like inflation and asset bubbles can arise, posing a threat to economic stability. In response, the Fed intervenes by raising interest rates. This action helps cool down the economy and keep growth on track.

Understanding Interest Rates and the Federal Reserve

The Fed’s main responsibility is managing the monetary policy of the United States, which involves controlling the money supply in the country’s economy. While the Fed employs various tools for this task, its most influential and effective tool is the ability to influence interest rates.

When people talk about the Fed increasing interest rates, they are referring to the federal funds rate, also known as the federal funds target rate. During its regular meetings, the Federal Open Market Committee (FOMC) establishes a target range for the federal funds rate. This rate serves as a reference for the interest rates that large commercial banks charge each other for overnight loans.

Banks borrow overnight loans to meet liquidity requirements set by regulators, including the Fed. The average of the rates negotiated for these loans is called the effective federal funds rate. This rate subsequently affects other market rates, such as the prime rate and SOFR.

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Due to this indirect arrangement, the federal funds rate becomes the most significant benchmark for interest rates in the U.S. economy, influencing interest rates globally.

The Impact of Fed Rate Increases

When the Fed raises the federal funds target rate, the objective is to raise the cost of credit throughout the economy. Higher interest rates make loans more expensive for businesses and consumers, resulting in increased spending on interest payments.

The fed funds rate affects the interest rates that commercial banks charge each other for short-term loans. A higher rate leads to more expensive borrowing costs, potentially reducing the demand for loans among banks and other financial institutions.

Individuals who cannot afford the higher payments or choose not to bear them may postpone projects that require financing. Simultaneously, it encourages saving to earn higher interest payments. This reduction in the money supply in circulation helps lower inflation and moderate economic activity, allowing the economy to cool down.

To illustrate the impact, let’s consider a 1% increase in the fed funds rate and how it affects the lifetime cost of a home mortgage loan.

Suppose a family is shopping for a $300,000 30-year fixed-rate mortgage, and banks offer them an interest rate of 3.5%. In this scenario, the total lifetime cost of the mortgage would be approximately $485,000, with interest charges accounting for nearly $185,000. Their monthly payments would amount to around $1,340.

Now, if the Fed had already raised interest rates by 1% before the family obtained the loan, and banks adjusted the interest rate for a $300,000 home mortgage loan to 4.5%, the family would end up paying over $547,000 throughout the loan’s 30-year term, with interest charges amounting to $247,000. Their monthly mortgage payment would be approximately $1,520.

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This simplified example demonstrates how the Fed reduces the money supply in the economy when raising rates. Besides mortgages, rising interest rates impact the stock and bond markets, credit cards, personal loans, student loans, auto loans, and business loans.

Immediate Stock Market Response to Fed Rate Hikes

Higher market interest rates can negatively affect the stock market. When the Fed increases rates, borrowing money becomes more expensive, resulting in increased business costs for public and private companies. Over time, higher costs and reduced business activity can lead to lower revenues and earnings for public firms, potentially impacting their growth rate and stock values.

Dan Chan, a Silicon Valley investor and former pre-IPO employee of PayPal, explains, “If borrowing money from a bank becomes more expensive, corporations may be unable to afford investing in capital goods. The interest rate might be so high that many companies cannot grow.”

Additionally, market psychology plays an immediate role in how stock investors respond to Fed rate hikes. When the FOMC announces a rate hike, traders might quickly sell off stocks and invest in more defensive options, without waiting for the long process of higher interest rates to permeate the entire economy.

The Impact on Bonds

Bonds are notably sensitive to changes in interest rates. When the Fed raises rates, the market prices of existing bonds immediately decrease. This decrease occurs because new bonds with higher interest rate payments will soon enter the market, making existing bonds with comparatively lower interest rates less attractive to investors.

Chan mentions, “When prices rise in an economy, the central bank typically raises its target rate to cool down an overheating economy. Inflation also diminishes the value of a bond’s face value, which poses a particular concern for long-term debts.”

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Increased Expenses for Mortgages and Home Loans

Rising interest rates indirectly impact long-term home loans, such as 30-year fixed-rate mortgages. Rates for shorter-term loans with adjustable rates, like home equity lines of credits (HELOCs) and adjustable-rate mortgages (ARMs), rise immediately following Fed rate increases.

The rates charged by banks for 30-year fixed-rate mortgages reference the yield on 10-year Treasury bonds. Usually, the 10-year yield is more directly influenced by Fed rate policy, although the fed funds rate represents only one of several factors contributing to 10-year yields.

Deposits Accounts Yield Higher Returns—Gradually

While higher interest rates may be detrimental for borrowers, they benefit individuals with savings accounts. The fed funds rate also serves as a benchmark for the annual percentage yields (APYs) on deposit accounts.

When the FOMC raises rates, banks respond by increasing the interest rates earned on deposit accounts. Consequently, APYs on savings accounts, checking accounts, certificates of deposit (CDs), and money market accounts rise as well.

Online savings accounts generally respond more rapidly to Fed rate changes due to increased competition among online banks for deposits. On the other hand, APYs offered by traditional brick-and-mortar banks respond more slowly to rate increases and tend to remain relatively low, even in favorable times.

Higher Costs for Credit Cards

When the Fed raises interest rates, credit card debt becomes more expensive. This is because the interest rates charged by credit card companies typically move in line with the federal funds rate.

The prime rate, which represents the rate banks charge their least risky customers for loans, serves as the basis for most credit card annual percentage rates (APRs). Credit card issuers calculate APRs by adding a percentage on top of the prime rate to cover their operating costs and generate profit.

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Most credit card APRs are variable, meaning the interest rate you initially agree to pay when approved for a new card can fluctuate based on changes in the prime rate. If your credit card APR is 18.15% and the Fed increases the federal funds rate by 75 basis points, your issuer would likely raise your APR to 18.90%.

The higher the interest rate applied to your credit card balance, the costlier it becomes to carry that debt. Consider reducing your debt as much as possible or taking advantage of a 0% APR balance transfer card to minimize the additional money paid on your debt.

Watch Out for Fed Rate Hikes

In February, the FOMC raised the federal funds rate for the eighth time since March 2022. Not all Fed rate hikes will directly impact you, and not all aspects of your financial life will be affected. Nonetheless, staying informed about changes in monetary policy is crucial to maintaining financial order.

For all investors, particularly those nearing retirement, it is essential to handle rising rate environments with caution. Just like in any other market conditions, finding the right asset allocation among stocks, bonds, and cash is the best way to mitigate the impact of rising rates.

Brian Stivers, president and founder of Stivers Financial Services in Knoxville, Tenn., advises, “Stock and bond markets often react unexpectedly to rising interest rates. Stock prices could go up when historically they have gone down. Therefore, diversification remains crucial in all types of markets.”

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