As you know Federal Reserve is increasing the interest rates trying to reduce the inflation. Over the last 12 months, inflation spiked to a 40-year high and only recently started to ease, but all of that monetary policy tightening has been tied to issues that are disrupting the banking industry now.
For consumers, that means they must pay a higher price to borrow while continuing to grapple with a persistently high cost of living — all while suffering a crisis of confidence when it comes to their savings accounts.
Incomes have not kept pace with inflation, which means purchasing power has declined as inflation has squeezed household budgets.
For its part, the Fed has already hiked its benchmark fund rate eight times over the last year to its current level of between 4.5% and 4.75%.
The federal funds rate, which is set by the central bank, is the interest rate at which banks borrow and lend to one another overnight. But Fed rates also influence consumers’ borrowing costs, either directly or indirectly, including their credit card, mortgage and auto loan rates.
What Happens When The Fed Raises Rates?
The Fed raises interest rates to slow down economic growth and prevent inflation from rising too quickly. While higher interest rates can have short-term effects on financial markets and the economy, they are generally seen as a necessary tool for maintaining a stable economy over the long term.
When the Fed raises the federal funds target rate, the goal is to increase the cost of credit throughout the economy. Higher interest rates make loans more expensive for both businesses and consumers, and everyone ends up spending more on interest payments.
The fed funds rate impacts how much commercial banks charge each other for short-term loans. A higher rate means more expensive borrowing costs, which can reduce demand among banks and other financial institutions to borrow money.
Those who can’t or don’t want to afford the higher payments postpone projects that involve financing. It simultaneously encourages people to save money to earn higher interest payments. This reduces the supply of money in circulation, which tends to lower inflation and moderate economic activity—in other words, cool off the economy.
Let’s look at how this applies to a 1% increase in the fed funds rate and how that might impact the lifetime cost of a home mortgage loan.
Take a family shopping around for a $300,000 30-year, fixed-rate mortgage. If banks were offering them an interest rate of 3.5%, the total lifetime cost of the mortgage would be approximately $485,000, with nearly $185,000 of that accounting for interest charges. Monthly payments would clock in around $1,340.
Let’s say the Fed had raised interest rates by 1% before the family got a loan, and the interest rate offered by banks for a $300,000 home mortgage loan rose to 4.5%. Over the 30-year life of the loan, the family would pay a total of more than $547,000, with interest charges accounting for $247,000 of that amount. Their monthly mortgage payment would be approximately $1,520.
In response to this increase, the family in this example might delay purchasing a home, or opt for one that requires a smaller mortgage, to minimize the size of their monthly payment.
This simplified example shows how the Fed reduces the amount of money in the economy when it raises rates. Besides mortgages, rising interest rates impact the stock and bond markets, credit cards, personal loans, student loans, auto loans and business loans.
Mortgage rates now average 6.66%
Although 15-year and 30-year mortgage rates are fixed, and tied to Treasury yields and the economy, anyone shopping for a new home has lost considerable purchasing power, partly because of inflation and the Fed’s policy moves.
The average rate for a 30-year, fixed-rate mortgage currently sits at 6.66%, up from 4.40% when the Fed started raising rates last March.
Average credit card rates now top 20%
Since most credit cards have a variable interest rate, there’s a direct connection to the Fed’s benchmark. As the federal funds rate rises, the prime rate does, too, and so credit card rates.
After a prolonged period of rate hikes, the average credit card rate is now over 20%, on average — an all-time high — up from 16.34% one year ago.
At the same time, households are increasingly leaning on credit to afford basic necessities, which makes it even harder for the growing number of borrowers who carry a balance from month to month.
Auto loan rates rose to around 6.48%
Even though auto loans are fixed, payments are getting bigger because the price for all cars is rising along with the interest rates on new loans.
The average interest rate on a five-year new car loan is now 6.48%, up from 4% one year ago.
Research shows keeping up with the higher cost has become a challenge as personal savings have dwindled and more borrowers fall behind on their monthly loan payments.
Federal student loans are already at 4.99%
Federal student loan rates are fixed, so most borrowers aren’t immediately affected by rate hikes. The interest rate on federal student loans taken out for the 2022-23 academic year already rose to 4.99%, up from 3.73% last year, but any loans disbursed after July 1 will likely be even higher.
Private student loans tend to have a variable rate tied to the Libor, prime or Treasury bill rates — and that means that, as the Fed raises rates, those borrowers will also pay more in interest. How much more, however, will vary with the benchmark.
Bank deposit rates at banks can reach 5.02%
While the Fed has no direct influence on deposit rates, the rates tend to be correlated to changes in the target federal funds rate. The savings account rates at some of the largest retail banks, which were near rock-bottom during most of the Covid pandemic, are currently up 0.35%, on average.
Thanks to lower overhead expenses, top-yielding online savings account rates are as high as 5.02%, much higher than last year’s 0.75%.
Although most savers don’t need to worry about the security of their cash at the bank, since if they hold less than $250,000 their deposit is fully insured by FDIC, still any money earning less than the rate of inflation still loses purchasing power over time.
Everyone is expecting interest rates cuts by the year’s end
Interest rate decisions are influenced by a wide range of factors, including inflation expectations, employment levels, and geopolitical events. It is difficult to predict with certainty whether interest rates will be cut or raised in the future, and any predictions should be taken with a grain of salt.
However, as we have seen many bank failures within a few recent weeks which could be mainly attributed to interest rate hikes, these banking system problems can throw Fed’s interest rate hiking policy out of the window.
One important caveat to market expectations is that traders don’t think any further rate hikes will hold. Current pricing indicates rate cuts ahead, putting the Fed’s benchmark funds rate in a target range around 4% by year end.
The biggest concern is that if the Fed continue raising the interest rates to beat the inflation, this eventually could lead us to stagflation, which is a very bad combination of high inflation along with recession.