How interest rate hikes ripple throughout the economy

A view of the US Federal Reserve in Washington, DC, on August 18. | Mandel Ngan/AFP via Getty Images

The Federal Reserve raised interest rates again on Wednesday. Here’s what that could mean.

The Federal Reserve raised interest rates by three-quarters of a percentage point on Wednesday in an attempt to bring the highest inflation in 40 years under control.

It was the fifth time the Fed has lifted rates since March, and another unusually large increase for the central bank. Inflation has recently started to slow: In August, prices rose 8.3 percent compared to a year ago, down slightly from July’s 8.5 percent, according to a Consumer Price Index report released last week. Still, higher prices have made it harder for Americans to afford basic essentials like food and housing.

When the Fed raises interest rates, the central bank is ultimately hoping to stabilize rapidly rising prices. The effect of this can ripple throughout the economy as higher interest rates make borrowing money more expensive. The Fed is effectively trying to slow the overall economy by reducing consumer demand for goods and services. The hope is that eventually, prices will stop growing so quickly if demand falls.

So far, the impact has been most visible in the housing market, which has suffered a severe downturn as mortgage rates have recently skyrocketed to their highest levels since 2008. But economists say the full impact of the Fed’s campaign to rein in inflation will become clearer in the coming months. And even though the labor market remains strong, higher interest rates can eventually lead to a rise in unemployment and fewer job opportunities.

“We have got to get inflation behind us,” Jerome Powell, the chair of the Federal Reserve, said at a press conference on Wednesday. “I wish there were a painless way to do that. There isn’t.”

Here’s what you need to know about how the Fed’s interest rates work and how they’ve already started to impact the economy.

What the Fed actually does is set a target for its benchmark federal funds rate, which determines the rate at which commercial banks borrow and lend money to each other overnight. Commercial banks are required to keep a share of their total deposits in an account with the Fed to ensure that the banking system remains stable. The exact amount a bank needs each day changes as banks do business, so they routinely lend excess reserves overnight if they have more than they need, or borrow from another bank if they don’t have enough to meet the requirement. When the Fed raises interest rates, it is effectively limiting the supply of money available to make purchases.

The federal funds rate can influence many other types of borrowing costs. Banks typically use the rate as a benchmark for their “prime rate,” or the rate they charge their most creditworthy customers. As the federal funds rate goes up, interest rates for many forms of consumer credit — including mortgages, car loans, and credit cards — usually follow. This can have broader impacts on the economy; as it becomes more expensive to borrow money, consumers could pull back on spending. That in turn could lead to slower economic growth and higher unemployment as businesses decrease production because of the drop in demand.

What happens to consumer loans when interest rates go up

So far, the higher rates have started to hit the most interest rate-sensitive parts of the economy.

Dean Baker, a senior economist and co-founder at the Center for Economic and Policy Research, said the Fed’s rate hikes have had the biggest impact so far on the housing market. Mortgage rates have soared over the past few months, largely because the Fed started to aggressively raise rates to tame inflation, Baker said.

On September 15, the 30-year fixed mortgage rate surpassed 6 percent for the first time since late 2008, according to data from Freddie Mac.

It’s a sharp reversal from the earlier days of the pandemic, when mortgage rates reached record lows as fears about the coronavirus and its impact on the economy spread (the 30-year fixed mortgage rate hit 2.65 percent in January 2021). Since monthly payments were cheaper, more homebuyers flooded the market. But supply was already tight, spurring bidding wars over available homes. That pushed up home prices to historically high levels.

Since higher mortgage rates make monthly payments more expensive, that has now begun to price out would-be buyers from the market. Sales of new and existing homes have plummeted in recent months as a result.

Higher mortgage rates have also led to slower home construction and souring sentiment among homebuilders. Although housing starts, or the start of construction on new residential housing units, unexpectedly rose to 1.575 million units in August, starts are still slightly down compared to a year ago. And building permits plunged 10 percent from the month before, signaling slower construction in the coming months.

The drop-off in home construction and housing demand doesn’t just impact people who are trying to buy a house. If fewer homes are being built, that could translate to fewer job opportunities or even layoffs among contractors, architects, and other workers in the construction industry as business slows.

The fall in housing demand could also impact companies that sell lumber, concrete, and other building materials. And when people buy homes, they tend to fill them up with new appliances and furniture, such as refrigerators, dishwashers, and couches. Demand for those bigger-ticket items tends to fall as home sales drop.

For the people who do purchase homes, they’ll be spending more on their mortgage payments now, meaning that they’ll likely have less money to purchase other goods and services.

Buyers could see some relief in the coming months, though, since home price growth is already starting to decelerate, Baker said.

“We haven’t seen much of a fall in sale prices, and that’s because the data really lags,” Baker said. “That will show up, I have no doubt.”

Interest rate hikes also affect other forms of consumer credit, such as car loans and credit card debt. Access to car loans dropped in August for the fourth straight month, according to the Dealertrack Credit Availability Index. The index fell to 102.5 in August, a 0.8 percent decline from the month before.

Jonathan Smoke, the chief economist at Cox Automotive, said it has become more difficult for some consumers to get car loans in recent months, largely because the Fed’s rate hikes have resulted in lenders charging higher rates.

“The Fed wants to see less credit flowing, and they are getting what they want,” Smoke said.

Although there are many other factors that can influence car loan rates — such as credit history, the loan term, and the type of vehicle — Smoke said the Fed’s aggressive rate hikes and tightening monetary policy have been the “primary catalyst” for the shift. Higher loan rates and rising new vehicle prices have worsened affordability and led to a slowdown in used auto sales compared to a year ago, mostly among lower-income individuals and people with poorer credit, Smoke said. New vehicle sales are also down from a year ago, but mostly because of a lack of supply, he added.

Still, overall demand for new and used cars remains high, largely because supply chain issues have made vehicles scarce during the pandemic. Used vehicle prices have started to come down slightly, but new vehicle prices continue to climb.

Many credit card issuers also tie the rate they charge to the prime rate, meaning that it has become more expensive for people to hold credit card debt as interest rates have increased. The average annual percentage rate on a new credit card reached 18.16 percent as of September 21, according to data from Bankrate. That’s up from 16.53 percent at the end of May.

How interest rate hikes affect everything — not just cars and houses

The Fed’s interest rate hikes don’t just influence consumer loan rates. The impact can spill over into the broader economy, affecting everything from consumer spending and business activity to the stock market and unemployment rate.

As it becomes more expensive to borrow money, consumers and businesses should in theory spend less. And if the Fed’s rate hikes spur a downturn in the labor market and more people are laid off or grow worried about losing their jobs, they could also pull back on spending, which would hurt economic growth.

Overall, consumer spending is starting to slow but remains strong, said Michelle Meyer, the chief US economist at the Mastercard Economics Institute. Part of this slowdown, though, is likely caused by inflation itself: Because prices are high, consumers are cutting back on spending, economists say.

Consumer spending rose 0.1 percent in July, the weakest pace this year and down from a 1 percent increase in June, according to Commerce Department data.

Although the Fed can significantly influence consumer demand for big-ticket purchases like new homes, there are some factors the Fed can’t control, Meyer said. Food at the grocery store and energy prices, for instance, are less sensitive to interest rate increases, so the trajectory of prices may depend more on factors like global supply-chain disruptions.

“If you look at the last CPI report, inflation at grocery stores was the highest since the late 1970s,” Meyer said. “So it’s a challenge.”

Business expansion can also take a hit when the Fed increases interest rates. As demand falls and borrowing costs increase, firms could ramp down production. So far, business activity is holding up but showing signs of weakness, economists say.

For instance, new manufacturing orders have slowed from the earlier days of the pandemic as businesses have grown more uneasy about the Fed’s interest rate hikes.

The Institute for Supply Management’s new orders index — which measures new order volumes in manufacturing industries like food, textiles, and computer and electronic products — rose to 51.3 percent in August, up from 48 percent in July. Still, that has signaled a drop in demand for factory products compared to a year ago, when new orders reached 65.5 percent in August 2021.

“It’s pretty clear manufacturing activity has slowed down quite a bit,” said Omair Sharif, the founder and president of research firm Inflation Insights. “My suspicion is that a fair chunk of that is because the Fed is raising rates and people were seeing that it was slowing demand, especially in the second quarter, and they pulled back on a lot of the orders that they had.”

Higher interest rates have also hit the stock market hard as investors have grown wary about the Fed’s rate hikes. The S&P 500 is down nearly 20 percent since the start of the year, Sharif said.

“A lot of what we’ve seen happen in the stock market over the course of this year is just concern about the Fed tipping the economy into a recession, on top of all of the geopolitical stuff that’s going on,” Sharif said. “A recession would definitely hurt corporate profits.”

Meanwhile, the job market is still strong

Eventually, the Fed’s rate hikes could lead to a significant uptick in unemployment and fewer job opportunities. As demand slows and corporate profits are hurt, businesses could pull back on hiring or even lay off workers as a result. But economists say that largely hasn’t happened yet.

Job growth slowed in August compared to previous months, with employers adding 315,000 positions to the economy (the month before, 526,000 jobs were created). But employers have been adding hundreds of thousands of jobs back to the economy for months after the labor market took a hit earlier during the pandemic, so it’s unsurprising that the pace has started to slow down.

“Monthly job growth has slowed, but it’s slowed down I think largely because it was unsustainably strong during the pandemic recovery,” said Robert Dent, a senior US economist at Nomura Securities.

The labor market is beginning to show some cracks — the unemployment rate rose to 3.7 percent in August, up from 3.5 percent the month before. But the rate was already at a half-century low in July, and the labor force grew as more people searched for jobs, which pushed up the rate.

Some tech and real estate companies — such as Netflix, Microsoft, and Redfin — have already started to lay off workers or pause hiring plans. Many executives have pointed to concerns about a potential recession as the Fed slows down consumer demand.

But federal data shows that overall, layoffs are low and job openings remain high, meaning that employers are still struggling to fill all of their open positions. In July, there were 11.2 million job openings, which translates to nearly two job openings for every unemployed person.

There are concerns, however, that labor market conditions could worsen as the Fed continues to raise rates. Powell, the Fed chair, has said the labor market is too hot and that conditions will likely soften as the Fed tries to bring down inflation.

Diane Swonk, the chief economist at KPMG, said she didn’t expect to see overall job losses in the economy until the end of this year or early next year, in part because the economy is still struggling to deal with labor shortages.

“The Fed themselves have said, well we need to see some kind of an increase in unemployment to slow things down more,” Swonk said. “But that may be a harder thing to get than they anticipate.”

What this all means for inflation

Inflation is starting to slow down, mostly because prices for gasoline, used cars, and airline fares have declined in recent months. But overall prices in August were still 8.3 percent higher than they were a year ago, which is uncomfortably high for both consumers and policymakers. The gain was driven by a rapid pick-up in food, housing, and medical care costs.

In July, consumer prices rose 8.5 percent from a year before, and in June, prices climbed 9.1 percent.

Inflation drove up during the pandemic as people used their pent-up savings to buy things like exercise bikes, work-from-home equipment, and new appliances. There wasn’t enough supply to meet that strong demand, though. And global factory shutdowns from the coronavirus, with other supply chain disruptions, made it even harder to produce and deliver goods. That in turn pushed up prices.

The Fed is still far from its goal of 2 percent annual inflation over time. But eventually, economists say, the Fed’s rate hikes should help slow price gains more substantially.

Joe Brusuelas, the chief economist at consulting firm RSM, said the impact of monetary policy tends to act with a lag, so it could take nine to 12 months before the fuller effect can be seen more broadly throughout the economy.

“We really are beginning to see the first impact of the price stability campaign put in place by the Fed,” Brusuelas said.

Kathy Bostjancic, the chief US economist at Oxford Economics, said she expected to see inflation slow more substantially by the middle of next year as the Fed continues to raise rates, predicting that overall inflation, according to the Consumer Price Index, would ramp down to 2.8 percent by the end of 2023.

Still, she said the slowdown in prices would likely bring more pain to the labor market. Bostjancic said she expected to see the unemployment rate rise to 4.8 percent by the end of next year, up 1.1 percentage points from its current level.

“I think there’s more to come,” Bostjancic said. “That combination of higher interest rates is going to help cool demand and then that in turn hurts corporate profits. When companies see their profit margins diminish, they tend to pull back on hiring.”

Update, September 21, 4 pm: This story has been updated with comments from Federal Reserve Chair Jerome Powell.