Jerome Powell addressing a press conference
Source: Federal Reserve Twitter

Raising Interest Rates Has Far-Reaching Consequences

Anuradha Garg - Author
By

Jan. 28 2022, Published 10:35 a.m. ET

At the Fed’s first meeting for 2022, concluded on Jan. 26, the committee signaled that it plans to begin raising interest rates soon, aggressively unwinding last year’s bond-buying. Why does the Fed raise rates, and what does raising interest rates do?

Article continues below advertisement

Due to the pandemic, the Fed has kept federal fund rates near zero to stimulate the economy, which was reeling from the COVID-19 pandemic. However, with inflation at multidecade highs, rate hikes are needed. At its Dec. 2021 policy meeting, the Fed forecast three rate hikes in 2022.

The Fed’s dual mandate

The Fed has a dual mandate of maximizing employment and maintaining stable prices. It achieves that in various ways, such as monetary easing and tightening, open market operation and reserve requirement adjustments, and federal funds rate changes. The latter has far-reaching consequences.

Article continues below advertisement
fed dual mandate
Source: Federal Reserve Twitter

The federal funds rate is the short-term interest rate at which U.S. financial institutions lend money to each other. The Fed sets a target for this rate, and in the process, all other rates are impacted, including short and long-term interest rates. The rates usually filter down to banks, which pass it on to their consumers.

Article continues below advertisement

Impact of higher interest rates on businesses and consumers

When inflation is running hot, the Fed increases interest rates. This causes the borrowing costs for consumers and businesses to climb, leading them to postpone or cancel projects that involve financing. Consumers are also left with less disposable income as interest on credit rises, reducing discretionary spending. Higher rates slow down business activity as well, slowing economic growth.

Article continues below advertisement

On the other hand, higher interest rates motivate people to save more and curtails money circulating in the system, tempering inflation.

Higher rates’ impact on stock and bond markets

Raising interest rates also impacts stock and bond markets, as higher rates increase the discount rate for a business’s cash flow. Growth stocks, which are expected to have cash flow in the far future, are impacted the most. The overall decline in consumer demand due to higher rates also hurts businesses, impacting their stock prices.

Article continues below advertisement

When interest rates are raised, value stocks usually do better than growth stocks. Banks and financial institution stocks also end up doing well, as they achieve wider margins and more profits on loans and financial transactions. Real estate stocks and home construction stocks are usually the worst hit.

As for bonds, there's an inverse relationship between bond prices and interest rates. As interest rates rise, the prices of existing bonds decline immediately because the new bonds released carry higher interest rates. Ideally, when interest rates are raised, you should reduce your long-term bond allocation in favor of short- to medium-term bonds, and shift some of your portfolio from growth to value stocks.

Advertisement

Latest U.S. Economy & Politics News and Updates

    Market Realist Logo

    © Copyright 2022 Market Realist. Market Realist is a registered trademark. All Rights Reserved. People may receive compensation for some links to products and services on this website. Offers may be subject to change without notice.