The Federal Reserve aims to keep the economy of the United States humming—not too smooth, not too dull, but just right. When the economy “runs hot,” distortions such as inflation and economic bubbles can become out of control, jeopardizing financial stability. When the Fed intervenes and raises interest rates, it helps to cool the economy and maintain the pace of development.

The issue

To keep up with soaring living costs, customers are expending more and saving less and increasing interest rates aren’t helping. The Federal Reserve is expected to raise interest rates by three-quarters of a basis point next week, while some on Wall Street believe it may opt for a total basis point rise.

Fed policymakers have already boosted baseline short-term borrowing rates by 1.5 basis points this year, including the highest hike in almost three decades in June. A basis point is the same as a per cent. Furthermore, authorities have hinted that additional hikes are on the way unless runaway inflation shows signs of slowing.

“With the heated month-over-month and year-over-year figures coming in as they have,” said Mark Hamrick, veteran economic analyst at Bankrate.com, “the Federal Reserve seems to have more work to do with rising interest rates to finally accomplish its goal of stable prices, or reduced inflation, in this case.” Any rate hike by the Fed will result in a rise in the par value, raising financing costs for many forms of consumer loans.

Short-term interest rates would be the first to rise. “Within one to three reporting cycles, changeable-rated debt tends to track Fed swings,” said Greg McBride, Bankrate’s top financial expert.

The Federal Reserve and interest rate relationships

The Fed’s primary responsibility is to manage monetary policy in the United States, which entails regulating the amount of money in circulation in the country’s economy. While the Fed has several instruments at its command for this purpose, its capacity to affect interest rates is perhaps the most visible and powerful monetary policy weapon.

When the Fed raises interest rates, they are alluding to the federal funds rate, often known as the federal funds target rate. The Federal Open Market Committee (FOMC) establishes a benchmark rate for federal funds at its regular meetings. It is a reference for the interest rates central commercial banks charge each other for abrupt loans.

Banks obtain overnight loans to meet liquidity requirements imposed by authorities such as the Fed. The applicable federal funds rate is the median of banks’ rates for overnight lending. This affects other market rates, such as the prime and SOFR. The federal funds rate is the most significant baseline for interest rates in the US economy. Thanks to this rather indirect structure, it impacts interest rates throughout the world economy.

Once the Fed raises interest rates, what happens next?

The Fed’s purpose in raising the federal funds’ threshold is to increase credit value across the economy. Higher interest rates mean borrowing is more expensive for firms and individuals, with rising interest payments for everyone. Those unable or unwilling to make the additional instalments postpone initiatives requiring finance. It also stimulates consumers to save money to obtain more significant interest payments. This decreases the quantity of money in circulation, which tends to cut inflation and limit economic activity—in other words, chill the economy.

What this means for checking accounts and deposits

While increased interest rates may be detrimental to borrowers, they benefit everyone with a checking account. The fed funds rate is a baseline for deposit account yearly percentage rates (APYs). When the FOMC interest rates increase, banks increase the amount you earn on deposit accounts.

That means the APYs on savings, checking, certificates of deposit (CDs), and money market accounts will climb. Because online banks compete for deposits, online savings accounts often react more quickly to Fed rate increases. Traditional brick-and-mortar banks’ APYs respond significantly more slowly to rate rises and rarely reach incredibly high levels, even in the best circumstances.

The Effect on Consumer Debt

Consumer credit, such as private loans, lines of credit, and credit cards, responds to Fed rate rises more gradually. Variable rate loans are especially susceptible to changes in the Fed funds rate since the interest rates they impose depend on criteria that reflect the Fed funds rate. New fixed-rate loans may have higher interest, but current ones are not affected by changes in the fed funds rate.

For example, from 2004 to 2006, the Federal Reserve hiked interest rates multiple times, from 1.0 per cent to 5.25 per cent, to combat inflation and calm an overheated economy. The cost of credit cards and line of credit borrowing increased as commercial banks raised their rates to 8.25 per cent.

Banks’ reactions

Analysts predict JPMorgan Chase, Bank of America, and Citigroup will report higher net interest income in the second quarter, which begins this week. Net interest income is the difference between what banks spend on deposits and what they make on loans and other assets. “Main street banking seems to be under tremendous strain over the past decade, owing to near-zero interest rates for most of that period.” 

So it’s now returning to a more reasonable interest rate environment than the prior decade, “said Mike Mayo, a banking analyst at Wells Fargo. Banks gain from rising interest rates because they can raise lending fees faster than growing deposit payments. According to Mayo, the pace of increasing net interest income from 2022 to 2024 will become the greatest since the 1980s as the Fed continues to raise rates this year to battle inflation. According to Fed data, loan demand is also increasing, particularly in industrial and commercial borrowing and credit card loans.

Expectations

On July 14, JPMorgan would be the first bank to report profits, followed by Citi the next day and Bank of America on July 18. Morgan Stanley and Goldman Sachs report earnings on July 14 and 18, respectively, focusing on investment banking and trading. While higher rates help banks, the Fed’s rapid rate hikes fuel fears of a US downturn in the next one and a half years.

Bank equities are often among the most hit during downturns, and experts anticipate that lenders will respond to the bleak economic outlook by putting aside additional capital to brace for the possibility of bad loans. “The true matter then becomes how violently they pile up the reserves in the provision of a probable economic stoppage or downturn in the following 12 to 18 months.” RBC research analyst Gerard Cassidy remarked.

Provisions for credit losses

So far, banks have reported that borrowers’ credit quality has been robust, with many firms and retail consumers still sitting on money from stimulus programs implemented during the coronavirus outbreak. Investors are looking for signals that this may be changing. “It’s fantastic to see a healthy quarter of credit expansion and favourable signs,” said Jeff Harte, research associate at Piper Sandler.

More proactive loan loss provisioning is a characteristic of new accountancy known as “currently anticipated credit losses,” or “CECL,” which went into effect in 2020. “This is a quarter in which banks put up or shut up in positions of problematic loan stashes,” Mayo added. The rising recession risk coincides with a decrease in commercial investment banking, particularly in equity capital markets through transactions such as initial public offerings.

According to Bloomberg projections, JPMorgan, BofA, Citi, Goldman, and Morgan Stanley are projected to post a year-on-year reduction in investment banking fees of about 40%. Analysts predict that total revenue at those institutions will shrink by a median of 4.6%. Trading revenue from turbulent financial markets will likely compensate for part of the shortfall. Vigorous trading activity should be paid for by sluggish banking activity, said Christian Bolu, a banking analyst at Autonomous Research.

Watch out for the Fed increase.

The Federal Reserve began raising the fed funds rate in March 2022. Not all Fed rate rises will immediately impact you, nor will rate changes touch every aspect of your financial life. However, keeping track of changes in monetary policy is crucial to keeping your finances in line. All investors, particularly those nearing retirement, must be cautiously handled in rising rate environments. As with any other market circumstance, the best strategy to offset the impact of increasing rates is to strike the correct asset allocation across stocks, bonds, and cash.

“Many times, the equity and bond markets respond unexpectedly to rising interest rates,” says Brian Stivers, founder and president of Knoxville-based Stivers Financial Services. “This means stock values might rise when they have historically fallen.” “As in all markets, diversity is essential.”

Influence of anticipation

For the equity market to respond to interest-rate increases, nothing needs to occur to consumers or businesses. Rising or declining interest rates might also affect investor psychology. Firms and individuals will reduce their expenditure whenever the Federal Reserve proposes a rate increase. As a result, earnings and stock values will decline, and the marketplace may collapse in expectation. Whenever the Federal Reserve declares a rate drop, the idea is that consumers and companies will boost spending and investment. As a result, stock prices may climb.

These generic, normal reactions may not apply if expectations differ significantly from the Federal Reserve’s actions. Assume the Federal Reserve is projected to decrease interest rates by 50 percentage points at its next session but instead announces a 25 basis point cut. So, because an assumption of a 50 basis point drop has already been factored into the market, the news may lead equities to fall.

The business cycle and the state of the economy can also influence the market’s reaction. When an economy begins to deteriorate, a minor boost from reduced interest rates is insufficient to balance the negative impact on economic activity; equities may continue to fall. Conversely, after a booming cycle, whenever the Federal Reserve begins to raise rates in response to increasing corporate earnings, specific sectors, such as tech stocks, growth companies, and leisure and recreational firms, frequently do well.