Federal Interest Rate Hikes and What it Means for Our Economy

Photo by Markus Spiske on Unsplash

Savoring that omelet? After the deadliest outbreak of avian flu in U.S. history, infecting more than 58 million birds in the month of January alone, perhaps you should. In fact, the national average for a dozen eggs has soared to $4.33, three times last year’s price. 

Even discounting the fowl epidemic, it’s undeniable that inflation is running rampant in America, reaching its highest levels in four decades with an annual rate of 8.00% in 2022. To counteract these rising inflation rates, the Federal Reserve began hiking the federal fund rate since the onset of the Covid-19 Pandemic in March 2020. Since March 2022, the Fed has more aggressively pursued these ends, a trend that continues to dominate into the new year. However, on February 1, the federal funds rate has only risen by a quarter of a percentage point from the past year’s benchmark point of 4.25% to 4.50%. How does today’s federal fund rate add up to historical ones? For one, it definitely pales in comparison to the 20% federal funds rate seen in the 1980 Recession after former President Nixon abandoned the gold standard and witnessed inflation in the double-digits. However, it’s not as preferable as the effectively zero federal fund rate seen in the 2008 Great Recession enacted in response to rising unemployment. 

How exactly do hiked interest rates curb inflation?

Put in simple terms, inflation is the measure of the rate of rising prices of goods and services and occurs when consumer demand exceeds supply, decreasing purchasing power. The Federal Reserve, the central bank of the United States responsible for steering the economy towards public favor, does not like excessive inflation. Thus, in order to cut down on consumer demand and in turn, inflation, the Federal Reserve tries to raise the interest rates that banks charge their customers by exploiting its power as the “bank of banks.” Yet the Federal Reserve cannot control interest rates itself; it can only influence them by raising or lowering the federal funds rate, which is the interest rate that banks charge each other overnight to borrow money. To make matters even more complicated, the Federal Reserve cannot directly set the federal funds rate but rather only a target range for it. Finally, the Federal Reserve Board meets eight times a year to make slight adjustments the size of a quarter to half of a percentage point to this range in response to fluctuations in our nation’s economy. 

But what does this mean for our economy? 

In general, when interest rates increase, fewer people and businesses take out loans from banks, decreasing spending. Consequently, demand declines and the job market growth slows. During periods of high interest rates, companies attempt to ensure peak profitability in an unfavorable market by cutting down on unnecessary costs, one of the many incentives that led major tech firms such as Google and Meta to recently lay off tens of thousands of workers. Consumers during this time are also encouraged to save, reducing the supply of money in circulation and thus, mitigating inflation.

Federal interest rate hikes can take a long time to ripple through the economy before bringing down inflation rates, negatively impacting short-term rates on credit cards and consumer loans. A hypothetical family looking to buy a new house may choose to postpone that decision or purchase a smaller living space than originally intended in order to avoid extra costs on mortgage. In terms of the stock market, because companies have less potential to grow and raise revenue from the increasing costs of doing business, many investors choose to pool their money out of riskier stocks, flocking to more defensive investments instead. As a result, stock values decline and market growth is rendered stagnant. 

All of these consequences may seem dire for the average consumer, but sacrifices taken by the current market are necessary in order to prevent even higher inflation rates in the future. However, only time can tell how long that’ll take.