Rising borrowing costs that consumers and businesses pay for loans have the effect of slowing economic activity, which in turn could dampen inflation. But there are also fears that it brakes too quickly. We asked Alexander Kurov, a finance professor at West Virginia University, and Marketa Wolfe, an economist at Skidmore College, to explain what the Fed does and what it means for you.
1. Why is the Fed raising interest rates?
Short-term interest rates in the United States are now virtually zero.
The Fed quickly cut rates to zero at the onset of the Covid-19 crisis in March 2020 in an effort to soften the blow from the deep recession that began that month as the United States locked down. As a reminder of just how bad things were back then, more than 40 million workers – a quarter of the American workforce – filed for unemployment in the first months of the pandemic, a staggering number unprecedented in the labor market.
Although the recession was short-lived – lasting only two months – and the economy has largely recovered, the Fed has kept rates low as many workers and businesses still need support as the pandemic continues to rage.
The big problem for the Fed now is that US consumer prices have jumped. For 10 consecutive months, inflation has been above the Fed’s 2% target and reached an annual rate of around 7% in December. This is the highest inflation rate recorded in the United States in the past 40 years. High inflation means that the prices people pay for goods and services are continually rising – especially for basic items like meat and gasoline, as well as for manufactured goods like cars.
The Fed can ill afford to let this continue because if higher inflation takes hold, it will hurt the economy. And the longer it goes on, the harder it will be – and more painful for consumers and businesses – to bring it back to a more sustainable level of 2%.
The Fed must therefore act quickly before it is too late.
2. How does the Fed raise rates?
The Fed sets a target range for what is called the “federal funds rate”. This rate acts as a benchmark for all interest rates in the economy.
Although the Fed did not say when it plans to raise rates, analysts expect the first hike to come in March, likely 0.25 percentage points. This would affect banks’ cost of borrowing, which in turn slowly filters through the whole economy as lenders charge more for loans on homes, cars, businesses, tuition and whatever else you might want to buy with debt. Banks would also gradually increase the interest they offer on deposits and savings accounts.
The Fed does not directly control all of these other rates, and the exact path they will take is not completely predictable, but the overall trend will be up if the Fed continues to raise its target rate.
Markets expect the Fed to raise interest rates at least twice more in 2022.
3. What does this mean for consumers and businesses?
Simply put, higher interest rates mean borrowers should pay more for the loans they get.
If the Fed raises interest rates this year by 0.75 percentage points, as expected, that would translate to about US$45,000 in additional interest payments on a $300,000 30-year mortgage.
So if you want to borrow to start a business, pay for your education, buy a car, or do anything else, you should expect your borrowing costs to be higher later this year.
On the other hand, higher rates are good news for savers and investors, as their returns from activities such as deposits and buying bonds will increase.
4. And how will this affect the broader economy?
Higher interest rates would likely slow business activity. While this may help reduce inflation, it also means lower economic growth.
The Fed always makes decisions based on what is happening in the economy and how economic conditions are expected to change. And changes in the economy are often difficult to predict.
The biggest unknown at this point is what will happen to inflation later this year. This is uncertain as inflation is fueled by multiple factors, such as supply chain shortages and high demand.
Additionally, the labor force participation rate has still not returned to pre-pandemic levels and the economy is experiencing labor shortages, which could drive up wages and prices. If these Covid-19 pressures do not ease quickly, inflation could remain high or continue to accelerate, which could force the Fed to raise interest rates faster than currently expected.
On the other hand, if economic or employment growth stagnates, it will be much more difficult for the Fed to raise rates without making matters worse. The Fed will have to find the right balance between controlling inflation and avoiding slowing the economy too much.
(This article is republished from The Conversation under a Creative Commons license.)