Q&A: "How will interest rate hikes impact me?"

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Here's the question we'll be tackling today:

Hey Nicole! My name's Carl and I live in Brooklyn. I've been seeing the updates that interest rates are going up. How will Americans be affected? Thanks!My two cents?

Interest rates are being raised in response to inflation (you can read my primer on inflation, How Inflation Changes Your Day-to-Day, here) But long story short: inflation has skyrocketed— it’s now clocking in at almost 9%, and we’re feeling that elevation everywhere, especially in grocery stores and gas stations. Last year, Treasury Secretary Janet Yellen said she didn’t think that inflation was going to be a problem. Earlier this month, she admitted she was wrong— and you know it’s bad when someone in Washington admits that they’re wrong.

When the U.S. needs to lower inflation, the Federal Reserve steps in. The Federal Reserve— or just “the Fed”— is the government branch that acts as the central bank of the United States. The Fed works with commercial banks to adjust the amount of money in supply and interest rates, and therefore, inflation.

I’m going to give you the golden rule of interest rates first, and then dig into why that rule exists. Here’s the rule:

To encourage spending, the Fed wants to make it easier to borrow money, and so the Fed lowers interest rates.

To slow inflation, the Fed wants to make it harder to borrow money, and so the Fed raises interest rates.

Let’s unpack this.

During tough times (like a pandemic), when people anticipate that money will be hard to come by, they want to keep what they have. However, that’s problematic because when people don’t spend money, the economy grinds to a halt.

Simply put, in recessionary times when people have less spending power, the economy hurts. People don’t buy their lattes, they don’t go out to eat, they don’t go back-to-school shopping. That means, the owners of their local cafe, restaurant and office supply store don’t have any money coming in, and their business suffers. When businesses suffer, they layoff employees, and the web of the economy starts to unravel.

The government, in order to keep the economy running, will want to boost spending power. In order to do that, the government can do things like issue stimulus checks, but they can also intervene with the money supply and interest rates so that it’s easier for people to borrow money.

The government’s rationale is: if the economy is slowing down, let’s make it easier for people to borrow money so they have money to spend. But it’s not only individuals that the Fed wants borrowing money, it’s also businesses. Remember those cafes, restaurants and office-supply stores who needed to lay off employees? If businesses can easily borrow money, they can keep their employees happy and, more generally, keep the lights on.

So far, so good, right? It seems like this solution of infusing the economy with money helps keep people employed and drinking their lattes. A win in my book. And lowering interest rates and encouraging spending is what the Fed did at the beginning of the pandemic.

However, when the government pumps money into the economy, it’s often the case that the money supply is growing faster than the supply of domestic goods. This can result in inflation (again, more on this here). And it did. Because of the cuckoo-bananas rate of inflation, the Fed now needs to pull back what they did to encourage spending during the pandemic. This is where interest rates come in. The Fed is raising interest rates so that it’s harder to borrow money.

Now, you may be thinking: "Wait a minute… so you’re saying that the Fed is trying to slow the economy? Didn’t we just say that’s a bad thing and leads to recessionary times?" Yes, you’re exactly right. The concern here would be that the Fed makes it too hard to borrow money, which in turn, lowers spending, and ultimately brings us back to the economic issues we were seeing at the beginning of the pandemic.

But, the Fed is trying to avoid that and shoot for what they call a “soft landing” — which the New York Times describes as a state of Goldilocks perfection, in which growth is neither too fast nor too slow, and prices are just right.

The Fed has signaled that by the end of the year, interest rates will be around 2.5%— and the Fed is hoping that 2.5% is that perfect, Goldilocks rate.

Is this good news?

Higher interest rates are good for some people and bad for some people.

If you have debt or are planning on taking on debt, that includes credit card debt, a car loan, a mortgage, a business loan, then your interest is going to be higher. That means you’ll end up spending more to pay off your debt in the long run, which we don’t like. If you’re a saver, you’re going to get more interest at the bank. That, we do like.

In anticipation of more hikes, it’s a good time to 1) pay down debt 2) if you have an adjustable rate mortgage and you’ve had a certain fixed rate that’s nearing an end, refinance 3) try to lock in a rate if you’re in the market for a car this year but aren’t quite ready.

xo,

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