Rate Hikes, Inflation, and You: The Fed’s First Line of Defense

Written by Jordan BlansitUpdated: 22nd Mar 2022
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If you’ve followed the news in recent months, you may have noticed a common cycle: economists warning about rising inflation, followed by the Federal Reserve refusing to act. But, after nearly a year of sky-high inflation culminating in a remarkable 7.5% increase by January – the largest in four decades – the Fed is finally ready to move.

The question is, how far?

What’s Driving Inflation?

Broadly speaking, inflation is the rise of prices over time, which leads to a loss of purchasing power. In other words, you have to spend more money to buy the same product.

Generally, inflation is driven by supply and demand. While you can divvy it up into different categories with various causes and effects, the basic principle is that when demand is high and supply is low, prices rise. Conversely, when demand drops or supply rises to meet it, prices drop.

Inflation is a common component of all economic systems and has been around for at least as long as currency (just ask the Romans.) In moderation, it can be a healthy driver of growth. In the United States, the Federal Reserve typically tries to keep inflation around 2%, which is considered just high enough to let the economy expand without letting it run too hot.

But when supply and demand mechanisms fall out of sorts, problems arise.

In particular, the current inflationary environment is a residual byproduct of Covid-19, which disrupted manufacturing and shipping chains worldwide. Labor shortages, product backlogs, and complex transportation logistics have made the price of everything from beef to cars skyrocket as supplies fall far short of demand. In the United States, post-pandemic wage increases have also contributed to rising inflation as workers have championed better pay. By January 2022, these factors had driven inflation to its highest point in four decades.

>> More: The Fed, Rising Interest Rates, and You: Tying the Threads Together

The Great Debate

Admittedly, the Fed can’t unclog backlogs or produce semiconductors out of thin air. But it can address the demand side of the issue by boosting the historically low-interest rates that currently allow economic growth to surge unchecked. Come the Federal Open Market Committee (FOMC) meeting on March 15-16, it will likely do exactly that.

But there’s plenty of debate over just how high – and how often – the Fed should jack rates.

For instance, the U.S. Federal Reserve Governor has suggested that the first jump alone could be as high as 50 basis points (0.5%). James Bullard, president of the Federal Reserve Bank of St. Louis, has made an argument for hiking interest rates to 1% by June. Investors, who often balk at the mere mention of higher rates, speculate that interest will rise to 1.5% by December.

Meanwhile, major banks are placing bets. According to a 10 February report from Goldman Sachs, the bank suggested that the Fed could hike rates as many as seven times in 2022 and an additional three in 2023. But on 28 February, the bank revised its prediction to four hikes in 2023, potentially bringing base interest rates as high as 3% by January 2024.

Despite rampant speculation and nail-biting in all corners of the economy, Fed Chair Jerome Powell has remained rather stoic. In the last FOMC meeting in January, he merely stated that officials have made no solid decisions about upcoming rate hikes.

So, until March 15-16, all we can do is speculate – and learn a little more about how rate hikes work.

What is a Rate Hike?

The FOMC meets eight times a year to discuss economic conditions and decide on monetary policies that affect the price and availability of money and credit. During these meetings, the FOMC also determines short-term interest rate targets, which in turn impact inflation, employment, and economic growth potential. (A single rate hike generally equals 25 basis points, or 0.25%, but not always.)

That said, the Federal Reserve can’t hike all interest rates. Rather, they manipulate one, known as the federal funds rate, which influences the price that commercial banks charge each other for overnight loans.

But the impacts don’t end there. As the federal funds rate rises, it becomes more expensive for banks to borrow. This effectively shrinks the money supply available, which makes money (and credit) more expensive to obtain. And as banks’ costs increase, they pass the buck to consumers and businesses.

As a result, when the Fed manipulates the federal funds rate, other interest rates change, too. For instance, when the funds rate rises, so does the prime rate, which serves as the base rate for consumer credit products like auto loans and credit cards.

But this still leaves another question: what do interest rates and inflation have to do with each other?

>> More: How Are Mortgage Rates Determined?

How does raising interest rates affect inflation?

In the United States, interest rates and inflation tend to share an inverse correlation. When interest rates rise, inflation falls, and vice versa.

The mechanism for this is multi-faceted, but still relatively simple.

As it becomes more expensive to borrow money, people stop shopping for houses and cars, spending extra on their credit cards, or taking out personal loans to fund their weddings. Meanwhile, businesses are less likely to invest in hiring workers or building a new factory if it means financing growth. At the same time, savings accounts generate more interest, encouraging consumers and businesses to save.

As the reward for saving begins to exceed the cost of spending, demand for goods – especially large, financeable goods – falls. As a result, supply increases, thereby depressing inflation (or even leading to deflation).

Winners and Losers in High-Rate Environments

In general, higher interest rates spell greater rewards for savers and bad news for borrowers, leading to:

  • Better earnings on your savings accounts and certificates of deposit (CDs)
  • More expensive credit cards, ARMs, and other variable-rate debts
  • Higher rates on new fixed-interest loans, which can decrease demand in loan-heavy sectors such as the auto and mortgage industries
  • An increased national debt as a result of higher borrowing costs for the government

Where Investors Stand

Investors’ relationship to interest rates tends to be similarly complex. As a rule, interest rates and stock market prices move inversely – but not in every sector, and not every time.

For instance, financial industries tend to profit off rate hikes, as they can charge more on loans without being seen as uncompetitive. U.S.-based companies also may see greater profits (or fewer losses) as the result of a stronger dollar compared to foreign currencies.

For most other industries, rate hikes have the potential to eat into business profits as the cost of borrowing grows. In turn, these businesses may post lower revenues come earnings season, which can cause market volatility if enough companies see a decline in profits or growth.

But a company doesn’t need to actually post bad results for the market react, as many investors act on expectations of business activity. The mere mention of a rate hike is enough to see the markets flinch as investors prepare for the worst. And if investors spy a company reducing growth or making moves that suggest it’s preparing for a poor earnings season, that can be enough to generate significant share declines.

However, the most obvious haven for investors fleeing the stock market – bonds – isn’t necessarily safe, either. Because bond prices and yields (interest rates) also share an inverse correlation, bond prices go down when interest rates go up. And the longer a bond has until maturity, the more it will fluctuate with interest rate changes.

How to Handle Rate Hikes

In such a hot inflationary environment, it’s not a question of when rates go up, but by how much. And with the Fed, major banks, and investors all predicting at least a year of rate hikes, it’s time to buckle down and prep your finances with a few easy money moves.

Refinance or Pay Down Your Debts

The first step is to shed that high-interest credit card debt or other variable credit lines, such as HELOCs or ARMs. For some, that may mean strapping down and paying more than your monthly minimum until the debt is gone. For larger sums, particularly mortgages or other home loans, you may want to refinance into a fixed-interest arrangement before rates jack up too high.

Boost Your Earnings

Unfortunately, high interest rate environments may lead to businesses cutting back on personnel expenditures. Before the Fed locks in too many rate hikes, consider going after an increase in income, whether you start your own business with a low-interest loan, invest in real estate, or ask for a raise.

Move Your Savings

The next step is to maximize your earning potential. Instead of sticking with the same ol’ savings account, you’ve had for years, shop around for a high-interest account that will net better returns. (Generally, online banks pay higher rates, but not always.) Even if you can’t find one that beats inflation, decreasing the loss of your purchasing power is generally better than staying put.

Invest in Value

For investors, handling high interest rates is a bit of a dance. While a long-term, buy-and-hold approach is generally best, that doesn’t mean you can’t generate some extra returns on current economic conditions.

To start, look into “all-weather” investments, such as companies that manufacture or sell necessities like groceries, household items, and personal care products. If you want to take advantage of high interest rates, you can also take a larger position in sectors that stand to profit, such as the financial, insurance, and healthcare industries.

Lastly, don’t be afraid to buy the dips. Short-term volatility can often make investors queasy, which may lead to losses if you abandon ship. But if you consider downswings an opportunity to purchase quality investments at a primo discount, you stand to profit from increased returns later. (Just be sure to select investments that you think will perform for years – not months.)

Jordan Blansit
Jordan Blansit

Jordan Blansit is a Senior Writer, Researcher, & Product Analyst for SimpleMoneyLyfe with an inexplicable predilection for mortgages, investing, and personal finance. When she’s not click-clacketing from the comfort of her living room, you can find her in the California Redwoods or Oregon Siskiyous. Jordan’s areas of expertise are mortgages, personal loans, credit cards, and investing.