What happens when the Fed raises interest rates?

The Fed will raise the cost of home loans, and cars for Americans, but the savings will also be a little more profitable. On May 4, the US Federal Reserve raised its reference interest rate by 0.5% – the strongest in 22 years. Back in March, the agency raised interest rates by 0.25% for the first time since the end of 2018.

The Fed’s move to 0% indicates that it is confident in the health of the labor market. However, the rate of interest growth also shows how much the Fed is concerned about inflation. US inflation in March rose at the fastest rate in 40 years. This could force the Fed to raise interest rates a few more times in the coming months.

Americans will feel the impact of this change. They will no longer be able to borrow at extremely low interest rates when they buy a house or buy a car.

The savings in the bank accounts will also be a little more profitable. “Money is no longer free,” said Joe Brusuelas – chief economist at RSM US.

When the pandemic loomed, the Fed almost lowered interest rates to 0% to encourage people to spend and businesses to invest. To further support the economy, the Fed has launched trillions of dollars into the market.

With credit markets frozen in March 2020, the Fed also launched emergency credit instruments. The Fed’s rescue policies worked. There is no financial crisis because of Covid-19.

Vaccines and the huge expenditures of the US Congress have paved the way for a rapid recovery. However, the fact that policies were launched urgently, but have not been lifted forever, has overheated the growth economy.

The unemployment rate in the United States is at least 50 years low, but inflation is very high. The US economy therefore no longer needs much support from the Fed.

Borrowing costs increased

The Fed reference rate applies to interbank overnight loans. While this is not the interest rate consumers pay, the Fed’s move may still affect the interest rates on loans and savings they are exposed to on a daily basis.

Every time the Fed raises interest rates, borrowing is more expensive. This means that all loans, from buying houses, buying cars, credit cards, paying tuition fees will be more expensive. The cost of borrowing with small and medium enterprises is also high.

Rising interest rates will make it harder to buy a house. US home prices have risen dramatically during the pandemic. Weakening demand could cool the country’s real estate market. The average price of homes in the US in March increased 15% year-on-year, to $375,000, according to the US National Real Estate Association.

How much can interest rates go up?

Investors expect the Fed to raise interest rates to at least 3% by the end of the year. The Fed once raised interest rates to 2.37% in the last rate hike at the end of 2018. Before the financial crisis of 2007 – 2009, this interest rate even amounted to 5%.

However, the impact on lending rates in the coming months depends mainly on the Fed’s rate of growth. And this is still undecided.

Good news for savers

Low-interest rates do not benefit depositors. The fact that the Fed kept interest rates close to 0% for 2 years makes savers almost nothing. If they subtract inflation, they’re even at a loss.

However, the good news is that savings rates will rise as the Fed raises its reference rate. The depositor finally has the interest but this takes time.

In many cases, especially with large banks, the impact will be hard to see overnight. And even as banks raise interest rates, savings rates are still very low, lower than inflation and stock market profits.

The markets will have to adjust

Low interest rates benefit the stock market, as it forces investors to bet on risky assets, such as stocks. However, high interest rates are also a challenge for the stock market, which is so familiar – if not addicted – to cheap money.

Recent markets have been volatile due to concerns about the Fed’s anti-inflation plan. However, much of this impact will depend on how quickly the Fed raises interest rates, and the underlying economic factors, how volatile corporate profits will then be. At a minimum, raising interest rates also means that the stock market will have to compete more with government bonds.

Does inflation bring down the temperature?

The Fed’s goal when raising interest rates is to control inflation, but to keep the labor market on track.

The Consumer Price Index (CPI) rose 8.5% in March compared to the previous year. This is the fastest pace since December 1981. Meanwhile, the Fed’s inflation target is only 2%.

Economists warn that inflation could be even worse, as commodity prices have skyrocketed since Russia’s military campaign in Ukraine. Everything from food, energy to metal has become expensive, even though oil prices have fallen as a result of the blockades in China.

The high cost of living is giving millions of Americans a headache, pushing consumer confidence to its lowest level in decades.

Of course, Fed policies take time to work. However, it depends on many factors, such as the conflict in Ukraine, supply chain disruptions and also Covid-19.

Impact on other economies

The Fed raises interest rates not only have an impact on the country’s economy, but also on many other countries. For example, Hong Kong and the Gulf countries – which anchor the local currency to the US dollar – raised interest rates shortly after the Fed’s move.

Hong Kong Monetary Authority (HKMA) on May 4 raised the base rate from 0.75% to 1.25%. Meanwhile, Saudi Arabia, the United Arab Emirates (UAE), Qatar and Bahrain raised by 0.5%. In addition, it puts pressure on developing economies.

Last month, IMF director Kristalina Georgieva warned the Fed and other central banks “to think twice about the risks spreading to vulnerable emerging and developing economies.”

The reason is that this can change the flow of global investment, causing capital to leave poor countries to flow to the United States. This will bring up the price of the U.S. dollar and push down the price of other currencies.

To protect the local currency, these countries may also raise interest rates according to, with consequences such as slowing growth, wiping out many jobs and businesses afraid to borrow. Indebted governments will also have to spend more on debt servicing, which in turn affects the budget for things like fighting epidemics or alleviating poverty.

DISCLAIMER: The Information on this website is provided as general market commentary and does not constitute investment advice. We encourage you to do your own research before investing.

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