What Does It Mean When the Fed Raises Interest Rates?

There’s been a lot of talk recently about the Fed raising interest rates. No matter where you get your news, the economy continues to be a primary topic and interest rates are one of the top headlines. 

But what exactly does it mean whenever the Fed raises interest rates? And why does it even matter?

There can be a lot of technical and complicated jargon around this topic. Below, we explore why this matters and what it means for your budget.

Why Does the Fed Raise Interest Rates Anyways?

To understand the effect that raising the interest rate has, it’s first important to understand why the Fed even does this in the first place.

Right now, the Fed’s primary goal is to get inflation under control. To combat inflation, the Fed is using one of the most powerful tools it has at its disposal: Raising the interest rate. The Fed has had six straight meetings in 2022, and in all of those meetings, they have voted to raise rates every time. 

So what does this have to do with inflation?

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Simply put, inflation is when there are too many dollars chasing too few goods. Some analysts attribute this to stimulus packages that pumped money into the economy to fight the economic effects of COVID. 

When there are too many dollars chasing too few goods, prices go up because the value of each dollar is less than it was before. This creates a downward spiral as companies in different sectors begin raising prices to compensate for increased costs. 

To fix this problem, the Fed’s strategy is to take money away from the economy.

So how do they take money out of circulation?

The Fed does this through raising interest rates. This benchmark federal fund rate becomes the interest rate at which banks borrow and lend to each other. 

Think of it this way: When you pay interest on a credit card statement, where does the money go? All of that interest is what the credit card company actually makes. They don’t make any money when you pay your balance every month. Rather, all the money they make in interest is theirs to keep.

Well, when the Fed raises its interest rate, the banks pay this – and the Fed keeps it out of the economy. This reduces the number of dollars, which increases the value of each dollar, which theoretically reduces inflation.

If this works, you should notice prices going down. 

But the economy isn’t a vacuum. In other words, there are ripple effects for everything that happens in the economy. It doesn’t matter if it’s a financial collapse on Wall Street or a decision from the Fed. Everything is economically interconnected now. This means that the Fed raising interest rates doesn’t just impact the banks.

It also impacts you.

What Does a Fed Rate Hike Mean for Me?

In the long run, a Fed rate hike should theoretically be good news for everyone. Why? Because it’s meant to keep inflation in check. As more dollars are taken out of the economy, prices should go closer back to normal.

But in the short term, this means pain.

The process of higher interest rates doesn’t just impact the banks – it also affects the interest rates that you are paying. Here are just some of the ways that rising interest rates have rippled through the economy.

• Higher mortgage rates. If you were going to get a 30 year fixed mortgage right now, the average interest rate is 7.68%. In 2019 right before the pandemic, interest rates were only 3.94%. This means that in 2 years, the interest rate on a home loan has nearly doubled. Because most people budget based on monthly payments, this means that people can afford less house/property than before, since more of the payment is going towards interest.
• Punishing credit card rates. It’s no secret that credit cards are among the most expensive types of credit. Right now the average credit card interest rate is 21.19%, though this number can go much higher for those with poor credit scores. Again, this is up compared to the 2019 average of 15.05, per the Fed. This will affect those with variable rates, not fixed rates.
• Unpredictable stocks. Again, there’s going to be a disparity between the long term goal and the immediate results. In the long term, this is good for businesses and stocks because inflation will be under control. But in the short term, this costs businesses more money because they have to pay more in interest rates. This means that they might wait to make major business investments until the economy returns to normal. To make matters worse, if the economy struggles, consumers will spend less, which impacts the bottom line. This results in an unpredictable stock market.
• Lower demand. Just a few months ago, we were all being pinched by an extremely hot car market, used car market, and housing market. With interest rates as high as they are, people are waiting to buy a new car or buy a new home. People want the best deal possible, so they won’t make the purchase unless they have to. This results in lower demand, which should mean lower prices.

What Do I Need to Do Financially?

There’s a lot of speculation about the ripple effects that the Fed’s actions will have on the economy. 

However, it’s best not to worry about the things that are outside of our control. Worrying over interest rates only causes more stress. The stress isn’t worth it, especially since we can’t control it.

Instead, we should spend our energy on the things that we can control.

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You see, the economy is always going to ebb and flow. This is nothing new. All we can do is focus on making the wisest financial decisions for ourselves. 

One of the best things we can do is to create and maintain a rainy day fund – also known as an emergency fund. This is a fund that we can tap into if financial difficulties ever head our way. During uncertain economic times, this can provide incredible peace of mind. For example, if there’s a recession and you're laid off, having an emergency fund ensures that you can continue to pay the bills while you search for another job. Similarly, if you have an unexpected expense (such as a punctured tire), you can handle the issue without having to use credit card debt to pay for it.

Most financial advisors recommend keeping an emergency fund that is large enough to cover 3 to 6 months’ worth of expenses.

I personally keep my money in CIT Bank because of their savings incentives. Their 1.00% APY for high savers is 7X the national average. In today’s economy, every penny matters. While the future is always uncertain, we can take steps to protect ourselves financially and, perhaps more importantly, provide peace of mind.

Are you investing in your own emergency savings account?