The Consumer Price Index was up to 7.1% in November over the prior 12 months; the Fed targets typical inflation rates to be closer to 2%, year-over-year. To try and tamp down inflation, the Fed has been raising interest rates in 2022 — raising the federal funds rate to 4.4% most recently.

This process is one tool of contractionary monetary policy. The goal of CMP is to reduce the amount of money circulating in the economy and help stabilize prices, but how does the process of raising interest rates actually work and how will it affect you?

How the Fed Attempts to Combat Inflation

The Federal Reserve System tries to maintain low rates of both inflation and unemployment, and manages the federal funds rate as a means to this end. Increasing the federal funds rate makes it more expensive for banks, consumers, and businesses to borrow (and ultimately spend) money.

A higher interest rate will make it more difficult and costly to buy things like cars, homes, furniture—basically, anything that is typically purchased on credit. With homes, mortgage rates have been on the rise; initially, this may not lower the inflation of home prices because there is a shortage of materials and labor, due to the pandemic. But as the shortages resolve, the theory goes, people wait to buy homes due to higher interest rates, cooling the market and dampening inflation.

The ultimate goal of raising the federal funds rate is to slow consumer spending. High interest rates disincentivize consumers and businesses from borrowing and thus spending, which should—in theory—bring down inflation.

Other ways that the Fed can try and cool inflation include:

• Federally-mandated price caps on goods
• Open market operations, or the selling of US Treasury bonds and bills
• Setting the discount rate (the rate the Fed charges banks that borrow money from it)

How Raising Interest Rate Can Help the Economy

It really comes down to controlling the costs of goods. By raising the interest rates, things like auto loans are more expensive, as the APR is higher than it was one year ago; this means that fewer people will be inclined to buy new cars, unless absolutely necessary, and the price for cars will need to drop to account for this lowered demand.

Over time, when the prices stabilize and inflation comes back down to expected levels, the dollar will have more purchasing power, which helps protect the worth of people’s savings.

Does Raising The Interest Rate Really Work?

We won’t know if raising the interest rate will work for at least a year, but it’s a strategy that has already slowed down the housing market, with a 22-year low in mortgage applications reported in August.

The fear is that raising interest rates too much and too quickly could slow down the economy, and in turn cause businesses to lay off workers or pause hiring. If the Fed miscalculates the rate hike and raises it too much, it could also send the US into a recession.

How Raising Interest Rates Impact You

There are five main categories where you might feel the impact of higher interest rates.

Home Loans/Mortgages

Shopping for a new home during a period of inflation, with rate hike increases, will be unpleasant. The average interest rate on a 30-year fixed mortgage hit 6% for the first time since the Great Depression, which is double what it was in 2021. Given that, people are delaying home-buying and refinancing until the rates drop.

Car Loans

Auto loans are fixed loans, however the rates for new loans have increased, as have the prices for new cars. If you are in the market for a new car, expect your monthly payment to be high until rates drop again.

Credit Cards

If you have credit cards with variable rates, they could rise in response to the rate hike. The average annual percentage rate of credit cards is 18%, an all-time record. If you have a credit card with a high APR, consider looking into cards with 0% balance transfers to tide you over until the financial situation improves.

Student Loans

Interest rates on Federal loans taken out for the 2022-23 school year have jumped to 4.99%, up from 3.73% in 2021. That rate definitely won’t change until next July, as Congress sets the rate in May based on the 10-year Treasury rate.

Savings Accounts

Now for a bit of good news: your APY on your savings accounts probably jumped this year, thanks to the rate hike. Some online banks are offering APYs as high as 2.5%, so it might be a good idea to move some cash around to reap the highest returns. That said, any account that sees returns lower than the rate of inflation will eventually lose purchasing power.

How Long Will Rising Interest Rates Last?

There’s no answer we can give that is entirely accurate, as there are many factors that influence the Fed’s decision to rise interest rates, but it’s speculated that the Fed will raise the rates at least one more time in 2022, by three-quarters of a percentage point, for a total raise of 2.25 percentage points for the year. There may be additional rate hikes towards the beginning of next year, but it’s expected that inflation may begin to level off by mid-2023, and at that point, rates would drop again, though prices may take longer to lower.

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