The factors that impact the health and productivity of the economy are numerous and sometimes complicated. That’s because the economy is a highly interconnected infrastructure built on elements like the labor market, consumer spending, production, investment, and more.
So sometimes, it can be difficult to see a direct correlation between your everyday life and something as abstract as monetary policy. But the truth is that this policy can have a very direct impact on the lives of everyday consumers. And if you’re paying close attention these days, the proof can be found at the Federal Reserve. The central banking system of the U.S. has spent the better part of the last year and change raising interest rates.
As inflationary pressures finally begin to cool off here in the summer of 2023, many consumers face new questions. In spite of a relatively low unemployment rate (hovering at a three-month mark of 3.5% over the course of the summer), some economists warn that a recession may still be looming.
With this threat still in the air, the federal funds rate continues to rise. At the time of writing in August of 2023, the Fed rate stands at 5.5%. This represents a 22 year interest rate high, with at least one more rate hike projected before the end of the year.
If you’re worried about the threat of a significant downturn, jump to our article on how you can better prepare for the possibility of a recession. Otherwise, read on to find out how interest rates work, what the reasons are for the current rate hikes, and how every single Fed funds rate hike impacts you as a consumer.
How does the interest rate work?
The Federal Reserve controls the federal funds rate, which in turn serves as the basis for the cost to borrow money. This borrowing cost is the interest rate that you, as the consumer, will pay on things like mortgages, auto loans, personal loans, and lines of credit.
The Federal Reserve sets the interest rate based on various economic factors. The ability to raise rates and lower rates as needed provides the Federal Reserve with a tool to be used against forces like inflation.
According to Bankrate, “the federal funds rate is used to control the supply of available funds and hence, inflation and other interest rates. Raising the rate makes it more expensive to borrow. That lowers the supply of available money, which increases the short-term interest rates and helps keep inflation in check. Lowering the rate has the opposite effect, bringing short-term interest rates down.”
This gives the Federal Reserve some power in tilting the scales of the economy. It has exercised that power aggressively when it has perceived the necessity.
Why is the interest rate so high today?
At present, it is clear that the Federal Reserve does indeed perceive it necessary to tilt the scales. As noted above, the Fed funds rate stands at 5.5%–it’s highest mark in more than two decades. Since just March of 2022, Fed Chair Jerome Powell has authorized 11 rate hikes.
So what’s behind the aggressive monetary policy?
Well, if you are a consumer, it probably won’t come as a surprise to know that the prices for everyday goods, services, and commodities have risen significantly over the last several years. We have endured a pattern of inflation which has impacted prices on everything from fuel at the pump to groceries at the checkout line; from housing prices to leases on new cars.
According to Bankrate, consumers suffered through a peak inflation rate of just over 9% in mid 2022. This period also coincided with a near record low in the federal funds rate. The COVID-19 pandemic temporarily crippled the global economy. In the midst of this unprecedented, unexpected and significant economic catastrophe, the Fed began cutting already low interest rates. By 2021, the Fed’s target range stood between .00% and .25%.
Prime borrowers saw this reflected in mortgage rates as low as 2.35% at the height of our pandemic-related economic swoon. Just two years later, the economy is in a very different place, with inflation rates at just 3% in June of 2023. Additionally, the Unemployment Rate hovers around 3.5%, which mirrors the pre-pandemic labor market.
How are current interest rates impacting the broader economy?
The Federal Reserve Bank may deserve some credit for this improvement. Indeed the Federal Reserve raised interest rates sharply and repeatedly just as inflation reached its peak. According to Bankrate, “The Federal Reserve announced that it’s raising interest rates by 0.25 percentage point, following its July 25-26 meeting, boosting the federal funds rate to a target range of 5.25 to 5.5 percent. With the move, the Federal Reserve has now raised rates a total of 11 times during this economic cycle in an effort to significantly reduce liquidity to the financial markets and tamp down high inflation.”
But of course, the Fed’s rate hikes are not without their risks. While a low unemployment rate is, on its surface, a good thing, there are some potential drawbacks. While we’ve seen a rapid decline in the rate of inflation, most consumers are still feeling inflation pressures in their everyday spending. Even if the value of the dollar is returning to full strength, consumers are not yet feeling much relief when it comes to the cost of goods.
When this pattern of events occurs, the Fed will typically raise interest rates as a way of slowing the rate of borrowing, production, hiring, and spending. The idea is that these factors will help cool some of the consumer demand driving up prices. However, some economists warn that pushing interest rates too high, too fast may tip the U.S economy into a recession.
An article in CNN describes the risk of a recession in the medium term to be fairly high. As CNN explains, “Dollar General slashed its forecast for the year and warned customers are being forced to ‘rely more on food banks, savings and credit cards.’ Macy’s blamed slowing customer demand for cutting its own forecast. Federal Reserve researchers have found that auto loan delinquencies are rising, surpassing pre-Covid levels. The other problem is the Fed’s war on inflation is hitting the economy with a lag. That means the full effect of the most aggressive interest rate hikes in four decades may not have been felt yet. This raises the risk the Fed overdoes it – or already has.”
These concerns highlight the central role that consumers play in either driving economic growth or contributing to a downturn. And in the next section, we’ll see exactly how rising interest rates can impact that role.
10 Ways Interest Rate Hikes Impact Everyday Consumers
While we’ve explored the ways that interest rates shape macroeconomic conditions, our greater concern as American households is how these rate hikes will likely impact us as everyday consumers. In short, the impact can be quite profound.
The Federal funds rate set by the Central Bank directly influences borrowing costs, savings patterns, spending habits, and more. Below, we take a look at ten ways the current trend toward rate hikes might be impacting you as a consumer.
1. Increased Borrowing Costs
When the Federal Reserve raises interest rates, borrowing becomes more expensive. The cost of borrowing begins with the rate that the Federal Reserve offers to banks. Banks start by borrowing money from the Central Bank at the Prime Rate. As noted, the prime rate at the time of writing is in a target range of 5.25% to 5.5%.
When lending this money to borrowers, banks charge a slightly higher interest rate. This rate will be based on each individual borrower’s qualifications. In the simplest terms, your credit rating will determine whether or not you are a risky borrower.
Those with excellent credit will be viewed as prime borrowers, and will enjoy the lowest interest rates on all types of loans and credit lines. By contrast, borrowers with less than sterling credit ratings will be viewed as carrying the risk of non-repayment. To mitigate this risk, credits and lenders will impose higher interest rates on these borrowers.
In other words, rising seas raise all ships. When the prime borrowing rate goes up, the borrowing rate goes up for everybody, from the best to least fit borrowers. Those most directly impacted by higher borrowing costs are consumers with variable-rate loans, such as credit card debt, adjustable-rate mortgages, and personal loans. Borrowers with loans structured this way will see their interest payments rise as the prime rate goes up.
This can lead directly to higher monthly expenses, which may place a strain on some households.
2. Higher Mortgage Rates
Of course, if borrowing rates go up, this means that the single most popular type of loan has also gone up in price. In short, higher federal interest rates can lead to an increase in mortgage rates. As a result, potential home buyers may face higher monthly mortgage payments, making home ownership less affordable.
This is a trend we are witnessing in real time. In the midst of the pandemic, the rising demand for new home mortgages caused a major spike in housing prices. This has been followed by the series of rate hikes we’re now experiencing. This only pushed home values further out of reach for some prospective buyers.
But the true danger is for those consumers with variable rate mortgages. According to an article from CT Insider, “home mortgages account for about 70 percent of combined household debt, which makes interest rate increases especially problematic for mortgage holders with adjustable rate home loans.”
Adjustable rate mortgages are those which begin with a lower introductory rate. While this rate is fixed for a duration, once that grace period expires, the interest rate will adjust to match the current market rate. This type of loan is often made available to non-prime borrowers–those whose credit history, debt or income may make them a lending risk.
In the face of a tumultuous economy and housing prices that have risen well beyond the means of many Americans, a growing number of borrowers have sought these adjustable rate mortgages. CT Insider reports that such borrowers actually accounted for 10% of all new home buyers in 2022.
While interest rates hovered above 3% at the time, the 30-year fixed mortgage rate for prime borrowers today is well over 7.5%. For subprime borrowers, the interest rate on repayment can be yet higher. For those with adjustable rate mortgages, the current trend from the Fed could cause serious financial hardship and even lead to a wave of foreclosures like the one we experienced during the Great Recession between 2007 and 2009.
3. Auto Loans
Interest rate hikes can also lead to higher auto loan rates. Consumers looking to finance a vehicle purchase today will receive interest rates more than three times higher than those available to the prime borrower just two years ago. This means monthly payments are higher for car buyers across the board, a fact which may be affecting purchasing decisions for some Americans.
And just as with the housing market, this comes at a challenging time for American consumers. The pandemic led to a number of trends in the automobile industry that conspired to raise prices for rentals, leases, and purchases. In the midst of the pandemic, with economic turmoil gripping the U.S., automobile sales tanked. Manufacturers and dealers responded by offloading inventory.
But in the midst of our economic recovery, a renewed demand for vehicles of every kind has strained an already short supply. This has only been compounded by near constant disruptions to the global supply chain–owing to a combination of logistical failures, labor issues, and materials scarcity.
All of these factors are being felt by consumers. Interest rate hikes only compound that impact. According to Reuters, “A shortage of cars for sale has sent car prices rising and now higher interest rates could make car loans more expensive. That’s because the short-term interest rates controlled by the Fed can indirectly affect the rates charged on auto loans. People who already have cars purchased with a fixed-rate loan shouldn’t be affected.”
However, if you have plans to purchase or lease a new car in the not too distant future, be aware that your interest rate will be much higher than it was the last time you went car shopping.
4. Credit Card Interest Rates
Credit card interest rates are also directly tied to the prime rate.
As Investopedia explains, “A hike in the Fed’s rate immediately fuels a jump in the prime rate, which is referred to by the Fed as the Bank Prime Loan Rate. The prime rate represents the credit rate that banks extend to their most credit-worthy customers. This rate is the one on which other forms of consumer credit are based, as a higher prime rate means that banks will increase fixed- and variable-rate borrowing costs when assessing risk on less creditworthy companies and consumers.”
This means that when the Fed raises interest rates, credit card issuers raise interest rates as well. As these credit card APRs go up, it becomes more costly for consumers to carry credit card balances. For some, this can also make it more difficult to pay down credit card debts without falling behind.
In other words, as interest rates go up, the risk that comes with using a credit card for spending that you can’t necessarily afford out of pocket also goes up. Carrying a large balance will cost you more both monthly and over the life of your debt. For those who struggle with debt, higher credit card APRs can compound the struggle.
5. Savings Rates
Most of the implications of rising interest rates described above come at a cost to consumers. With higher borrowing costs, the price of just about everything goes up. But there is a silver lining. The value of your savings can also rise during times of high interest.
Indeed, any time borrowing costs rise, savings rates tend to rise as well. This means that consumers who have savings accounts, certificates of deposit (CDs), or other interest-bearing accounts may see higher returns on their savings.
According to Investopedia, “Money market and certificate of deposit (CD) rates increase because of the uptick of the prime rate. In theory, that should boost savings among consumers and businesses because they can generate a higher return on their savings. On the other hand, the effect may be that anyone with a debt burden would instead seek to pay off their financial obligations to offset the higher variable rates tied to credit cards, home loans, or other debt instruments.”
Such is to say that your ability to actually seize on this benefit will depend a great deal on your financial condition. Not everybody has the luxury of saving more aggressively. In the face of so many higher consumer costs.
Many American households are already living by slim margins. Rising interest rates have only further eroded these margins. However, if you are already financially comfortable and you aren’t grappling to repay high interest debts, now would be a great time to put more money into your savings.
6. Impact on Fixed-Income Investments
As with interest on savings, interest on fixed-income investments like bonds and certificates of deposit does rise as the prime interest rate rises. The result of this higher interest rate may be higher yields in the short term.
As an article from the U.S. Bank reports, “The most recent peak in 10-year Treasury yields comes during a period of fluctuating interest rates in the context of an upward trending pattern. At the outset of 2022, 10-year Treasuries yielded just 1.5%, reflecting a longstanding lower interest rate environment. Yields rose dramatically in 2022, then fluctuated within a range of 3.30% and 4.25% before recently breaking through to a new high of 4.35% as of August 21, 2023.”
But this type of trend is not inherently positive. While those with fixed incomes, like retirees, saw higher income in 2023 due to these higher yields, there is a counter-effect. High yields may cause the market value of existing bonds to decrease, negatively impacting investment portfolios.
As the U.S. Bank explains, bondholders were particularly hard hit by these conditions in 2022, when according to the Bloomberg U.S. Aggregate Bond Index, fixed-income bonds generated a return of -13.01%. Even as retirees earn higher income today, overall returns remain relatively flat as of late summer 2023.
7. Reduced Consumer Spending
One of the major imperatives for the rising interest rates is the concern that the U.S. economy is “overheating.” The combination of aggressive production, hiring, and investment during a period of relatively high inflation pressures means that prices for goods, services, and commodities remain exceptionally high. As we have noted, even with inflation beginning to level out, consumers continue to pay elevated prices for everything from housing and transportation to groceries and utilities.
The Fed’s aggressive interest rate hikes are explicitly meant to cool the pace of economic growth, which should in turn continue to drive down inflation. However, cooling the pace of economic growth carries some pretty concrete implications. The higher borrowing costs spurred by rising interest rates can ultimately reduce the amount of disposable income available to households. This is especially true as many households seize on those higher interest rates by prioritizing saving goals.
Taken together, these factors can lead to decreased consumer spending. While this is indeed the type of economic slowdown the Fed intends to create, it can have a chilling effect on the retail economy. This in turn can translate to decreased revenues, business closures, and lost jobs.
8. Impact on Small Businesses
On the subject of business closures, many small businesses sit directly in the crosshairs when the cost of borrowing increases. Higher interest rates can make it more difficult for small businesses to finance day to day operations or pursue necessary growth.
Small and growing businesses often rely on loans for materials, equipment, labor costs, facilities expansion, and much more. Increased interest rates may stifle the ability of smaller businesses to grow and hire new employees. For those that are in the delicate stages of startup, this could restrict cash flow enough to result in failure.
To an extent, this is by design as the Fed takes steps to slow down the overheating economy. But that design comes with some very real growing pains.
9. Student Loans
The interest on repayment of federal student loans is generally set at a fixed rate that is insulated from federal funds rate hikes. This means that current and prospective borrowers of federal student loans will not typically be impacted by the higher rates.
However, many students rely on a combination of both federal and private student loans. Private lenders generally impose higher interest rates on repayment, and some loans may have an adjustable interest rate. This means that private student loans are more expensive in the current environment.
This, combined with the continually rising cost of a college degree, may impact decision making for students and families considering a higher education. The last several years have seen a decline in overall college enrollment. Higher borrowing costs may only further magnify this trend, which in turn may only intensify the financial crisis that many smaller colleges are facing today.
10. Housing Market Slowdown
We noted that the rising cost of mortgages is making it difficult for many Americans to afford home ownership. But this is not simply a trend impacting subprime borrowers. The cost of housing combined with the sky-high interest rate means that even prime borrowers may struggle to afford today’s prices. This carries macroeconomic implications.
Rising mortgage rates can lead to a slowdown in the housing market. As mortgage rates increase, potential buyers may be forced to delay purchasing homes, or may decide to put off their plans in the hopes that interest rates might ease in the future. These factors can combine to decrease demand on the housing market, which in turn may drive prices down on homes.
According to an article from CNBC, “A real-life example of this is playing out in the U.K., where an ongoing mortgage crisis saw mortgage rates hit a 15-year high in July. Many homeowners are unsure if they can afford the higher payments, while prospective buyers are being put off by the higher cost of borrowing.”
One could make a strong argument that housing prices should come down, and that these trends suggest some normalization of costs in a deeply overheated housing market. However, sellers, builders, contractors, adn developers will likely feel the pinch as the housing market slows.
The big takeaway from this discussion is that far reaching macroeconomic conditions can have a direct impact on the everyday lives of consumers. But of course, inflation and interest rates are just a few of the factors that shape our spending, saving, and investment habits.
For a look at another far reaching economic factor that may actually be hitting you right in the wallet, check out our article on 10 global supply chain issues impacting consumers today.