How the federal interest rate increase impacts you
You might know that the Federal Reserve—or the Fed—acts as the central bank for the U.S. And one of its responsibilities is to stabilize the financial system. To help with this, it sets the federal funds rate to respond to what’s happening with the economy.
Because federal interest rates can affect everything from mortgages to new credit cards, it’s helpful to understand how and why the federal funds rate increases—and the impact these hikes could have on personal finances.
Key takeaways
- The Federal Reserve sets the monetary policy, which includes setting the federal funds rate, to help stabilize the economy.
- When the federal funds rate is raised, it becomes more expensive to borrow and spend, which ultimately can slow the economy down.
- Higher interest rates could lead to higher returns for savings accounts and certificates of deposit (CDs).
What is the federal interest rate increase?
The federal funds rate is the interest rate financial institutions pay for borrowing and lending overnight. This rate is set by the Federal Open Market Committee (FOMC), a board of policymakers from the Fed. They meet eight times a year to reevaluate and set the current rate.
The federal funds rate is used to help stabilize the economy and promote economic growth. When there are threats of inflation or a recession, the FOMC may fluctuate the funds’ rate to help cool the market.
Why does the Fed raise interest rates?
Occasionally, the federal interest rate is increased or decreased. The FOMC does this to help promote conditions that increase employment rates, lower inflation and create sustainable long-term interest rates.
What happens when the Fed raises interest rates?
When the Fed raises interest rates, the impact can be felt throughout the economy and on consumer-based products.
Credit cards
Typically when the Fed rate increases, so does the prime rate. The prime rate is used by individual banks to determine what interest rate to extend to borrowers on most forms of credit. And the annual percentage rate (APR) for credit cards tends to increase alongside the prime rate.
Consumer loans
As interest rates and borrowing costs increase due to the hiked federal funds rate, consumers are typically less likely to take out loans. With personal loans or auto loans, an increase in interest rates could make it more difficult for borrowers to finance these larger purchases knowing that they’ll have higher monthly payments.
Mortgages and home sales
Mortgage rates may also be impacted by the federal funds rate. That’s because mortgage rates tend to fluctuate with the yield of 10-year Treasury notes, which are investments issued by the U.S. government. These 10-year Treasury notes are impacted by interest rates, so when their interest rates increase, so do mortgage rates.
When rates are lower, the price of a home generally becomes more affordable, incentivizing buyers to make a purchase. This can help increase sales in the housing market.
Savings accounts
Savings accounts and CDs could see high-yield growth when the federal funds rate increases. That’s because banks may use consumer deposits to fund loans. However, saving yields don’t typically rise as significantly as other interest rates do.
Stock market
Due to the volatility of the stock market, it’s hard to predict exactly what will happen. But in general, when the federal funds rate rises, the stock market tends to go down.
Because consumers may have less disposable income during these times, business profits tend to decrease. And that can have a negative effect on stock prices and earnings.
Consumer spending
Federal interest rates can have a direct impact on consumer spending and purchasing power. With an increase, it’s more expensive to borrow money, so consumers are generally less likely to make impulse purchases. They might also feel the impact of higher prices on many consumer goods and services.
Business profits
An increase in the federal funds rate can have a positive impact on business profitability for financial institutions, although most other sectors will typically feel a negative impact. The cost of capital generally increases during this time, making it harder to expand and increasing operating costs.
Unemployment rates
Another effect of increased federal interest rates can be rising unemployment rates. When businesses are faced with decreased profits and higher operating costs, the hiring of new employees may come to a halt, and production may decrease. This could cause companies to make layoffs, which might raise the unemployment rate.
How often does the Fed raise interest rates?
While the FOMC meets eight times a year to update its federal interest rate projections, not every meeting will result in an increase or decrease in the federal interest rate. And sometimes emergency meetings are called.
At the start of 2023, the Fed increased the federal funds rate to its highest rate in more than a decade—and at the single fastest yearlong pace since the 1980s, according to Bankrate.
Here’s how that compares to historical changes in the federal funds rate:
- 1980-1990: To help cool inflation, the Fed’s first rate hikes brought the federal funds rate to an unprecedented 19%-20%. Rates eventually started to fall to 10% by 1984 and haven’t surpassed that rate since.
- 1991-2000: After a recession, rates stayed between 3% and 6.5%.
- 2001-2010: In the early 2000s, rates began to fall. Following a recession and the 9/11 attacks, interest rates in 2003 were down to 1%. By 2008, the Great Recession had set in. In December 2008, the Fed had cut interest rates by 100 basis points to 0%-0.25%.
- 2011-present: Rates stayed below 2.5% for most of this time until the COVID-19 pandemic. The Fed called emergency meetings in March 2020 to cut rates to near zero. With inflation concerns in 2022, the Fed approved a .25% increase in March. Rates increased seven times in 2022, mostly by 50 or 75 basis points each time.
Federal interest rate increases in a nutshell
To help stabilize the economy, the Federal Reserve sets the federal funds rate. And this rate can be used as a basis for financial institutions when it comes to making lending decisions such as setting mortgage rates and determining a credit card’s APR.
Because increases in the federal funds rate can be felt across various financial sectors, it may help to be prepared by practicing strong financial habits. Learn how something like setting credit limits for yourself could help you prepare for any unexpected fluctuations in the market.