What does an interest rate increase actually mean?

Would you like to receive more content just like this directly to your inbox? Click here to subscribe!

You’ve probably seen on the news recently that interest rates are increasing. The Federal Reserve last year laid out a plan to incrementally increase the Federal Funds Rate over the course of 2022. There are a variety of reasons for that, but maybe more importantly, what does that actually mean? How does an increase in “interest rates” impact your daily life?

When you see discussions around increasing interest rates, what’s generally being referred to is the Federal Funds Rate set by the Federal Reserve. The Federal Funds Rate dictates the interest rate different banks will pay to one another to hold required deposit amounts overnight. Increasing or decreasing that interest rate can have far-reaching implications on a variety of other interest rates in a kind of ripple effect.

Why would the Federal Reserve want to increase interest rates now?

The Federal Reserve is the central bank of the United States; a kind of quasi-governmental entity who has two primary mandates. Those mandates include 1) trying to keep US unemployment as low as possible, and 2) keeping inflation under control. * The end goal of these two mandates is ideally to encourage economic growth across the US.

In pursuing those mandates, the Federal Reserve or “the Fed” has one very large lever it can pull, that being increasing or decreasing the Federal Funds Rate. If the economy isn’t doing so well, the Fed may elect to lower interest rates to make taking out a loan cheaper, which in turn encourages businesses and consumers to take on debt at a relatively low interest rate. For a business, if they can then invest those loan proceeds and create a higher return than the interest rate, that’s a win. For consumers, a lower rate might make it easier to buy that new home or new car you’ve been wanting, which in turn stimulates economic activity by creating income for all the parties involved (realtors, car dealerships, etc.).

Over the last two years, we’ve been in what some would refer to as a rollercoaster of economic growth.** The pandemic nearly shuttered the US economy for a time, but once many of the lockdown measures ended, economic growth came roaring back to the point where businesses couldn’t find enough workers to help satisfy pent up demand. The economy was growing aggressively. Simultaneously, international supply chains were strained to produce many of the goods we often consume. The net result of both situations is rapidly increasing prices (i.e., inflation), setting the stage for the Fed’s rationale to raise rates now.

By increasing rates overall, the Fed is basically agreeing to sacrifice economic growth today to reduce the rampant inflation being experienced across the country. Over the last year, prices on everything from bread to oil have been increasing at rates not seen in decades. By increasing the cost of lending over time, the Fed, at least in theory, is hoping that tapping the brakes on economic growth today will slow then crazy price increases we’ve been seeing.

So when the Fed increases the federal funds rate, how does that impact you?

When the Fed increases the Federal Funds Rate, it sets off a kind of ripple effect that impacts other interest rates you’re probably more familiar with. The largest of these is the prime rate, which is the prevailing rate that’s used by most banks to set rates on many of the products they provide to consumers. Credit cards, mortgages, auto loans, and home equity loans all typically have their rates determined based on the prevailing prime rate. As a result, when the Federal Funds Rate increases, the corresponding rates on all of these products will change relatively quickly in response.

Over time, other rates will also begin to increase on things like checking accounts, high-yield savings accounts, and money market accounts. Even longer term, the interest rate on new bond issuances will eventually begin to increase with prices on existing bonds potentially declining as a result.

How will each of these outcomes impact you? The answer is going to be highly dependent on your situation. For a long time, holding cash in large amounts has been a generally poor approach for a lot of individuals because the yields on almost any savings account weren’t able to even outpace inflation. Barring the need to use a large amount of cash for something like a major purchase or for emergencies, it generally wasn’t a great option. That isn’t likely to change immediately, so for a lot of people the question of what to do with excess cash continues.

Near term, making sure you’re updating your financial plan to reflect changes to various interest rates is an important first step. Maybe it impacts you, maybe it doesn’t, but without having a plan in place to understand the ramifications of increased interest rates to your specific situation, it’s really hard to determine what changes, if any, you should be making.

* https://www.chicagofed.org/research/dual-mandate/dual-mandate

**To be clear, the author of this article would refer to the last two years as a rollercoaster of economic growth.