Consumers are already paying more for gas, groceries and everyday items, but they should expect to fork over more in other parts of their lives after Wednesday’s interest rate increase.
The Federal Reserve’s move to rein in inflation will affect home mortgage loans, credit card borrowing, car loans, labor market stability and overall consumption. The goal is to reduce the amount of money supply in the economy.
“Too much money makes the money less valuable,” said Larry Harris, professor of finance at the USC Marshall School of Business and former chief economist at the US Securities and Exchange Commission. “To control inflation, the Fed has to stop creating so much money. And when it stops creating money, interest rates tend to rise.”
Though the Fed doesn’t set the interest rates consumers pay on their credit cards, mortgages or personal loans, it controls the federal funds rate, which is the basic rate at which banks borrow and lend from each other. When that moves, so do consumer interest rates.
Banks are required to have a certain amount of money in reserve, and when they make loans to people who want to buy homes, cars or start businesses, they might have to borrow from other banks to make sure they maintain that reserve number.
At this time last year, the interest rate for borrowing from the general banking system was 0%, said Leo Feler, a senior economist at the UCLA Anderson Forecast. At that rate, banks were more than willing to make loans to consumers because there were basically no costs involved in covering their reserves. But now, with a higher interest rate range of 1.5% to 1.75%, banks will want to ensure they have enough in reserve and act more cautiously, making fewer home, auto or other loans as a result, he said.
The financial markets were already pricing in the expectation of higher interest rates — for example, mortgage rates hit 6%. The question is: How high will they go?
“The Fed has telegraphed that it’s going to keep increasing rates until inflation comes down, no matter what it takes,” Feler said.
Here’s what consumers can expect to see after Wednesday’s rate hike.
The Fed’s benchmark interest rate hike will affect the minority of households who take out adjustable-rate mortgages or home equity lines of credit, likely increasing their cost to borrow.
Affected homeowners who have the option of converting to fixed-rate loans may want to consider doing so, said Harris of USC.
The impact on fixed rate mortgages — including the popular 30-year fixed loan — is less certain.
Mortgage experts said increases in the federal funds rate don’t directly affect these mortgages, but they can indirectly push fixed mortgage rates higher or lower if Fed actions influence investor thinking about how entrenched inflation is.
That’s because if inflation is expected to be high in the future, investors will demand a higher yield, or interest rate, on mortgages before they buy them.
Already mortgage rates have surged this year, rising from the 3% range in January to above 5% as of last week and by some measures have now topped 6%.
The sharp rise in borrowing costs has placed some home buyers into new price brackets and priced others out all together, causing home sales to fall in the process.
It’s possible that a larger-than-expected increase in the federal funds rate could convince investors that inflation will be tamed sooner and thus send fixed-rate mortgages down, said mortgage industry consultant David Stevens, who is also the former head of the Mortgage Bankers Assn.
Alternatively, larger increases in the Fed rate could spook investors and send mortgage rates higher, said Keith Gumbinger, vice president of research firm HSH.com.
credit card debt
Credit card interest rates aren’t set by the Fed, but they do move with the federal funds rate. When this rate rises, credit card interest rates will rise, too.
“With rising interest rates, people who have borrowed money at variable rates, like people who borrowed on their credit cards, should make an extra effort to reduce their balances as quick as they can,” said Harris of USC. “Otherwise, they’ll pay higher rates in the future, which will hurt them.”
Labor market mobility
The Fed’s higher-than-expected rate hike means hiring will likely slow down and there may be more layoffs on the horizon, said Feler of UCLA. He forecasts that the national unemployment rate will go up to 4.5% by the end of the year, up from 3.6% right now. As unemployment goes up, wage growth goes down, which will dampen consumer spending power.
That means people will be worried about keeping their jobs and could be less likely to ask for higher wages. Those in low-wage jobs or jobs they don’t like will be more likely to stay in their current positions for fear of being unemployed.
“The trade-off right now is that the Federal Reserve is willing to sacrifice some employment in order to make sure that inflation comes down because in the long term, if we continue to have such high rates of inflation, it really harms consumers,” Feler said.
This comes at a moment when hiring has been booming. In May, the US added almost 400,000 jobs, with unemployment remaining low. Businesses overall have been eager to hire to keep up with consumer demand for goods, though some sectors, especially those that thrived during the pandemic, such as Peloton and Netflix, have seen cuts.
Less demand for goods
High inflation has reduced shoppers’ purchasing power as price increases ate up any pandemic-related wage boosts. But consumers don’t seem to have significantly cut back on spending just yet. That means it might take longer for the Fed’s action to translate into a slow-down of consumer demand.
By tinking with the interest rate, the Fed is trying to influence demand in the economy. A hike in interest rates causes borrowing costs to go up and discourages consumers and businesses to spend less.
Consumers stop buying goods because they’re worried about losing their jobs. Discretionary expenses like going out to dinner or streaming services are cut. Sales of furniture and appliances slow because would-be home buyers are priced out of the market. Big ticket item purchases are nixed.
That means good news for your savings.
“It induces more people to save up because you want to reward people who are saving up or becoming savers,” said Feler of UCLA. “What you’re trying to get people to do is not go out and consume as much as they were consuming before.”