What happened when the Fed raised interest rates?

In a nutshell

In general, elevated interest rates encourage people to save money and discourage borrowing. The current rate-rising cycle has been different than other periods of rising rates in the 21st century because of its greater scope and faster rise.

• Prospective home buyers were priced out of the market or forced to consider lower-priced homes (if they could find them).
• Businesses that use financing in their operations were forced to cut back due to higher interest rates on bank loans and for bonds they issue, though the economy stayed strong, especially in the services sector.
• Rising rates dramatically affected the kinds of investments people made to preserve and grow their capital.

Stocks

Higher interest rates can be bad for some stocks. When rates rise, the cost of borrowing for companies can increase their cost of doing business. For companies that issue bonds or rely on bank loans to grow, the interest costs associated with this borrowing can be a real drain on their profitability unless the company can increase their prices enough to offset these added interest costs. On the other hand, some companies, like banks, may benefit from higher rates. As interest rates rise, they can charge more for lending money and potentially increase their profits.

Since the Fed started raising rates in March of 2022, many companies that relied on cheap financing, particularly speculative technology companies and startups but also banks with capital invested in tech startups and in commercial real estate have seen their share prices fall. The prospect of easing inflation at the end of 2023 convinced some stock market participants that the Fed would cut rates repeatedly in 2024, which set off a rally in major indexes like the Nasdaq, the S&P500 and the Dow Jones Industrial Average. Hot technologies like AI also boosted shares of companies in that field.

But inflation has not been extinguished entirely. As of March, 2024, inflation has persisted above the Fed's 2% target, reintroducing stock market volatility and keeping investors on edge about the possibility of rate cuts in 2024 or even a another rate hike.

Bonds

Bonds are extremely sensitive to rising interest rates. The value of a bond decreases when interest rates increase because the interest payments remain the same while the interest payments on other similar newly issued bonds are higher. In order to entice bond investors to purchase an existing bond with a lower interest payments, the price of the bond must drop in order to match the interest rate on newly issued bonds.

Bond mutual funds and bond ETFs saw their worst year in decades and possible ever in 2022 as rising rates depressed the value of their assets under management. Many funds rallied at the end of 2023, but that rally was put on hold as inflation flatlined in the first quarter of 2024. The upside of elevated rates for longer is that the yields on these funds will continue to improve as the economy digests the higher cost of money. Moreover, short-term bonds whether government bonds or corporate bonds now pay more than they have in decades. A buy-and-hold bond laddering strategy has come back from obscurity as the stocks TINA era (There Is No Alternative) comes to an end.

Credit cards

Credit card interest rates follow Fed interest rate hikes because credit card rates are usually tied to the prime rate, which is influenced by the Fed Funds rate. Since the Fed started raising interest rates in 2022, those carrying balances on their credit cards have seen their average APR rise from 16.3% to 22.8% according to the Consumer Financial Protection Bureau (CFPB).

This may be a good time to look into balance transfer offers with lower interest rates for a period of time. It can also be a great incentive to focus on paying off this debt as quickly as possible.

Mortgages

According to the St. Louis Federal Reserve Bank, the average 30-year fixed-rate loan reached its peak this century in November, 2023 at 7.63%. That was a amazing increase from a historic low of 2.67% on the last day of 2020. Rising interest rates on mortgages have a direct increase on the price that homebuyers must be willing and able to pay. On the other side of the transaction, sellers may be forced to lower their asking price in order to sell their home. Consequently, people who were able to buy houses at the end of 2020 have found themselves locked in to an ultra-cheap mortgage, and new homebuyers are often priced out of an increasingly expensive housing market.

The combination of higher interest rates forcing mortgage rates higher and increased inflation has put a damper on what has was a very hot housing market over the past several years. Sellers may have to rethink their asking price and some may decide not to sell after all. On the bright side, increased prices and demand have brought back activity in home building as housing starts have begun to recover from their post-pandemic slump.

Savings accounts

Higher interest rates are a good thing for those with savings accounts and other types of interest bearing deposit accounts. Banks generally raise the interest paid on deposits when the Fed raises interest rates. These accounts are one way banks bring in funds that they can then lend out. Generally the interest rate on the loans is higher than what they pay on savings accounts, so they make money on the spread.

Unfortunately if you have your savings in a savings account with less-that-optimal APY, the bank may not increase your savings rate on its own. Savers looking for the best rates should consider checking out online banks and financial institutions as they generally offer higher rates and often react to changes in prevailing interest rates more quickly than brick and mortar banks.

AP Buyline roundup: Fighting inflation in a robust economy

The Fed raises interest rates to fight inflation while trying to avoid crashing the economy into a recession. So far, it seems as if the central bank has been able to pull off this "soft landing," and that has been a boon to savers and investors alike. The key is to keep your eyes on the monetary ball and be ready for the next phase in this interest rate cycle.