If you've been following the stock market at all these past few months, you've likely heard about the "rate hikes" being cooked up over at the Federal Reserve.
It's a short, technical-sounding phrase, but when it comes from the mouth of a Federal Reserve chair, it can move markets and strike fear or relief into the hearts of investors.
Now the big day is finally here. Fed Chair Jerome Powell told Congress earlier this month that he supported a 25 basis point interest rate hike at the Federal Open Market Committee (FOMC) meeting in March. Unless the other Federal Reserve governors split from the chair — they pretty much never do — then a quarter-percent rate hike is all but certain.
But what, exactly, does this mean for investors, consumers, and businesses?
One commonly used metaphor describes the Fed's role as taking away the punch bowl just as the party is getting started. In other words, the Fed cuts off the supply of money before the economy gets too hot, and right now, the U.S. economy is the hottest it's been in over 40 years.
However, this one-to-one relationship between inflation and the money supply is a myth. What's actually happening behind the scenes is a lot more complicated, and it brings to light a number of interesting debates over whether or not rate hikes even do what we think they do.
Anatomy of a Rate Hike
First of all, let's break down what is literally happening. When the Federal Reserve raises interest rates, the first thing it does is set a new target range for the Federal Funds Rate.
Right now, that target rate is between zero and 0.25 percent, and it's been stuck in that range since the beginning of the pandemic, and really for much of the last decade.
So when people say the Fed is raising "interest rates," what they really mean is the Federal Funds Rate, which is not a universal measure of interest rates across the economy. Specifically, it's the short-term rate at which commercial banks lend money to each other overnight.
The overnight market is so important because it helps banks meet their reserve requirements: Banks with excess reserves can lend, while banks with too few reserves can borrow. Remember: the Fed requires banks to keep a certain percentage of their reserves against their liabilities. This is how it ensures banks have assets backing up their lending.
But the Fed can't just pick a number and rates fall into line. The target Federal Fund Rate is just a suggestion. The effective rate is the actual rate at which banks lend to each other. One does not automatically proceed from the other. The Fed has to intervene in the market to make the effective rate follow the target rate, and it does this through open market operations.
In the past, the Fed executed open market operations by buying and selling securities, usually U.S. Treasuries, from banks. When it wanted to lower the rate, it bought securities, putting cash into the coffers of banks. When it wanted to raise them, it sold securities, taking cash out.
That doesn't quite work anymore, because banks are flush with reserves due to a decade of the Fed purchasing U.S. Treasuries and mortgage-backed securities from banks. This process, called quantitative easing, has loaded up banks with reserves, which are then stored at the Fed.
Under this so-called ample-reserve regime, the Fed determines rates by adjusting the interest rate paid on bank reserves kept overnight at the Fed, setting a floor on rates for the rest of the economy. If the Fed raises what's called "interest on the reserve balances" (IORB), banks have less incentive to seek out riskier investments, thus pulling money out of the economy.
Trickling Down
So, this is what's happening at the very top of the economy — in the overnight lending market between banks — but how does this end up impacting everyone else?
The abbreviated answer is that higher rates mean tighter financial conditions, and this can happen in several different ways.
In the broadest sense, if it costs more for banks to lend to each other, those higher costs will trickle down to the rest of the economy. That could mean higher mortgage rates, higher interest rates on credit card debt, and higher rates for business and consumer loans.
"Interest rate hikes increase the cost of money," said Greg McBride, the chief financial analyst for Bankrate.com. "It increases the cost of borrowing. Safe investments earn more, so there are less incentives for risk-taking."
How this impacts you depends on your debt burden, whether or not your credit card and mortgage rates are variable or fixed, and whether you're invested heavily in stocks.
For example, the Federal Funds Rate can impact annual percentage yields on savings accounts, but those rates are already so low that most people won't notice a jump from the current average rate of .06 to .09, which is what happened after multiple rate hikes in 2018.
At the same time, the average annual percentage rate on credit cards is already historically high at over 20 percent, so some slight variation might go over consumers' heads. Conversely, it could also be the straw that breaks the camel's back and pushes them to default. Credit card delinquencies did tick upward through the second half of the 1990s as the Fed raised rates.
McBride said there's often a two-month delay before rate hikes spur higher credit card rates.
Mortgage rates, meanwhile, are more sensitive to the Fed rate and have already begun to spike in anticipation of today's hike.
What does this mean for the economy as a whole? Experts contend that higher rates translate into less business spending and investment. This matters to consumers because less business growth can mean fewer jobs, less income, and less consumer spending.
Again, the correlation isn't one-to-one. A number of factors inform whether a business invests in expansion or hiring, but historically higher rates have curbed economic growth.
What does all this mean for inflation? The Fed is essentially raising the price of money to cut demand and as many economists have pointed out this won't address the supply chain issues that have pushed up prices in the pandemic era.
It could, however, cut into demand enough that it relieves some pricing pressure. The big question is, can the Fed do that without starting a recession?
"The impact of one single quarter-point rate hike is pretty inconsequential, but if the Fed raises rates eight or 10 times over the next year or two, that has a meaningful impact," said McBride.
