Yesterday, June 15th 2022, the federal reserve (as expected), announced a 0.75% rate increase. I’ve seen a lot of folks wondering what higher rates mean, exactly, and how they are supposed to combat the recent inflation we’ve been experiencing here in the US.
Today I wanted to break down in a simple and straightforward way what the rate increase is intended to do, how it’s intended to fight inflation, whether this means we’re entering a recession, what it means to your savings, and how it impacts (or doesn’t) your debt. You can refer to the handy table of contents below to jump to your specific question if you would like.
What Is The Federal Reserve?
Let’s start with the basics – what is the federal reserve? The federal reserve (aka “The Fed” or central bank) is responsible for for monetary policy and financial stability in the United States of America. It’s composed of three key groups – the Board of Governors, the Federal Reserve Banks (12 of them), and the Federal Reserve Open Market committee. Jerome Powell, the person who’s in the news a lot, is the Fed Chair and the group that actually announced the rate increase is the Federal Reserve Open Market Committee.
Why Did The Fed Raise Rates?
The federal reserve announced they were raising rates by 0.75%, which is the largest jump since 1994, as a reaction to the recent news that inflation hit a 40 year high.
At the start of the pandemic the fed was afraid not of inflation, but deflation and decreased demand. So they got out their Great Recession playbook and slashed rates to help prop up demand (among other things). It appears they mis-judged both the roaring back of demand and decreased supply. High demand and low supply is perfect recipe for inflation. Combine that with the war in Ukraine, shutdowns in China, lots of people wanting to buy a new house after being stuck inside for months, the quick comeback of travel, the Great Resignation (increasing pay) – you have inflation.
How Do Higher Rates Impact Savings?
Generally speaking, higher rates should mean that you’ll earn more interest on your savings. Today, even high yield savings accounts pay under 1%. In an inflationary environment, such low rates are a recipe for losing money. In fact, my grandfather used to say that low rates were a kind of punishment on savers. Bringing the amount you can earn on your savings closer to the inflation rate (even if still below) helps preserve the spending power of your savings. It doesn’t necessarily happen immediately though, so it may be a bit before you see higher rates available on savings accounts again.
How Do Higher Rates Impact Mortgages and Home Prices?
Higher rates do make mortgages more expensive, typically increasing the mortgage rate. An increase in the mortgage rate means that your monthly payment is more expensive. Now this doesn’t impact you if you hold a fixed rate mortgage, because your rate is locked in. But it does impact you if you want to refinance (typically doesn’t make sense to do so at a higher rate); buy a new house (more expensive); or take out a home equity loan (more expensive).
Won’t making mortgages more expensive drive down, or at least stagnate, home prices? Yes, and that’s part of the point. Inflation is when prices go up, and home prices have been going up like crazy. House price inflation is usually seen positively if you already own a home but if you don’t, it’s harder to get into the market. So raising rates targets home price inflation by making mortgages more expensive.
How Do Higher Rates Impact Other Debt?
Higher rates impact your other debt in different ways, depending on what that debt is and how it’s structured. If you have some kind of fixed rate debt – like a car loan, or a fixed rate student loan – it won’t change your existing debt. But it makes new debt more expensive.
What if you have a variable loan, like say a variable rate student loan or credit card debt? Higher rates can mean those loans become more expensive. How much more expensive and when you’ll see the impact of the change depends on the specific loan.
How Do Higher Rates Impact The Stock Market?
You may have noticed the stock market has been headed down lately, then hit a big bounce up yesterday after the announcement. So you may be confused about how higher rates impact the stock market. The market doesn’t like higher rates because it makes borrowing more expensive. This can lower customer and business demand, and ultimately weigh on business earnings. Rates themselves at the moment are not particularly high compared with rates of recent past. But the market is fearful at the moment that this isn’t the last rate increase. Fear and uncertainty tend to make markets go down.
So then why the bounce up yesterday? Probably because the market gained a bit more certainty about exactly how much the fed was going to raise rates.
How Do Higher Rates Impact The Bond Market?
Not great news here either – when interest rates go up, bond prices go down. And new bonds pay a higher interest rate. This is great news for people who buy bonds. But not great news for companies who issue bonds, because it makes it more expensive for them to borrow.
But why would a higher rate cause bond prices to go down? Generally speaking it’s because older bonds, which pay less interest, become less attractive to an investor. Why would you buy a bond that pays 0.5% interest when you can buy a new bond paying 2% (for example)? In order to entice people to buy a bond that pays less interest, you have to sell them the bond at less than it’s worth. That way they “earn” the difference on that bond through a discounted price.
Will We Enter A Recession?
The market does seem to be predicting we’re going to head into a recession. Over the years I’ve observed that no one seems to be able to reliably predict when we’ll hit a recession. So it’s not something I can answer definitively, and nor can anyone else. And if someone tells you they can predict this, then they likely have a newsletter, a course, or a “secret” to sell you. Generally speaking the fed’s goal is to put the brakes on the economy. Enough to stop high inflation but not enough to cause a recession. So let’s wait and see together.
What Questions Do You Have?
Have a question I didn’t cover here? Some other key FAQ I forgot? Let me know in the comments.