What Happens When the Fed Raises Rates?

  • Higher interest rates by the Federal Reserve signal rapid and strong changes to economic conditions and bring recession scenarios back into discussion.
  • An overheating economy is not ideal or sustainable, so raising interest rates seems like the most effective solution to fight high inflation.
  • Everything from the U.S. Dollar to consumer spending is affected by higher interest rates, there are benefits for risk-averse investors with a considerable number of deposits.
A photo of the outside of the Federal Reserve Building.

Source: MDart10 via shutterstock.com

The U.S. economy and global economy are like the temperature. When they get too cold, they cause an unpleasant feeling. And when they get too hot, they give a high degree of discomfort to consumers and to businesses. In other words, when the economy is not overheated, there is a severe growth problem. To seek a lot of growth, which is always good, you must have a basic principle in place, demand must be stronger than supply. A flashback to the pandemic shows that the economy is often disrupted by external shocks.

The challenges caused by the Covid-19 pandemic made the Federal Reserve keep interest rates to near-zero levels to support the strength of the U.S. economy. In 2022, as we began to return to normal, conditions gained momentum, but another external shock occurred: high energy prices due to the war in Ukraine. As “U.S. consumer inflation accelerated to 9.1% in June, a pace not seen in more than four decades,” the Federal Reserve has to bring economic stability back, by lowering inflation.

The most effective way to do this is simply by raising the federal funds rate. Most recently, on July 27, the Fed raised rates another 0.75%. So, with that in mind, what happens when the Fed raises rates?

Recession Scenarios Return to Forecasts

The most important issue discussed after the latest historic interest rate hike by the Federal Reserve is the possibility of an economic recession. Is it possible? If so, how likely is it to come to fruition?

A recession is technically defined by two consecutive quarters of a decline in GDP, as GDP measures total economic activity. So why would higher interest rates cause a recession in the U.S. economy? Higher interest rates make it much more costly to borrow money and this may discourage consumer spending.

One of the ways to measure GDP growth is the expenditure approach which simply means GDP=C+I+G+(X−M), where ‘C’ equals consumer spending, ‘I’ equals investor spending, ‘G’ means government spending and (‘X’-‘M’) equal exports minus imports. All these parameters are affected by higher interest rates.

Consumers may borrow less and spend less. Investors may find the rising costs now make investments less profitable. The government may have to spend less as the taxes collected due to lower consumption will be less, and exports may become much lower as the U.S. dollar will probably appreciate relative to other currencies. The total effect is lower GDP, so a recession is very likely, and definitely a detriment for the total economy.

The Federal Reserve chairman has mentioned “We’re not trying to induce a recession … [we] are acutely focused on returning inflation to our 2% objective … The Federal Reserve’s strong commitment to our price-stability mandate contributes to the widespread confidence in the dollar as a store of value.”

Are these statements enough to reassure investors and analysts that a recession will not occur? It would be ideal to believe so, but things are not that simple. According to Yahoo Finance reporter Alexandra Semenova, “A survey released by the Conference Board found that 60% of chief executive officers and other C-suite leaders across the globe believe their geographic region will enter a recession by the end of 2023.”

Can the Federal Reserve Fight Inflation in Other Ways?

The Federal Reserve has a “weapon” called monetary policy in its hands to apply economic stability. It is the most effective way to stabilize things, but it comes at a very high cost. However, very high inflation is not ideal nor sustainable for economic activity.

High inflationary pressures erode the real value of savings and investments and undermine business activity as higher costs to run a business mean lower profitability. Lower profitability by businesses can make them reduce their workforce and increase the unemployment rate, which is not an ideal scenario either. I consider the Federal Reserve is doing things right now and it has no other choice rather than to continue raising interest rates until inflation returns to normal levels.

Higher Interest Rates Affect Everything in the Economy

I mentioned consumer spending and the risk of recession earlier. The stock market is impacted by higher interest rates as valuations get lower and borrowing costs get higher for businesses. A combination of lower revenues and earnings is very likely for most public companies with more than normal debt levels, which should lead to lower stock prices. Bonds, on the other hand, become more attractive as their yields move up and can now offer attractive returns, even by not taking inflation into account. For example, the U.S 10-year bond yield on June 14 was 3.49%, the highest yield in the past five years.

Higher interest rates mean there is a major allocation shift, from risk assets to safer assets. From growth stocks to value stocks. Potential asset bubbles that are a threat to economic stability can now be prevented more effectively. The U.S. dollar, in theory, will appreciate over other currencies, and this will lower net exports, making them more expensive to countries in the European Union for example.

There is also another factor that makes people with high deposits very happy. They get higher interest on their savings, which encourages saving and not spending. In the end, higher interest rates by the Fed completely change business and investing activity, while also impacting daily consumer spending decisions. It is a reset to economic conditions.

On the date of publication, Stavros Georgiadis, CFA  did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.

Stavros Georgiadis is a CFA charter holder, an Equity Research Analyst, and an Economist. He focuses on U.S. stocks and has his own stock market blog at thestockmarketontheinternet.com. He has written in the past various articles for other publications and can be reached on Twitter and on LinkedIn.

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