Why Does the Fed Keep Raising Rates?

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You didn’t see a lot of celebrating on Wednesday after the Federal Reserve raised its key interest rate by 0.75% for the third time in a row. Instead, the stock markets tumbled and economists warned of job losses and a weakening housing market.

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With so much bad news attached to interest-rate hikes, why does the Fed keep doing it? In 2022, the reason can be summed up in one word: inflation. Inflation — the rate at which consumer prices rise — has been growing at its fastest pace in more than four decades. In August 2022 it rose 8.3% from the previous year. The Fed hopes that its series of aggressive interest-rate hikes this year will slow that pace down.

As The Washington Post reported, inflation happens when there’s a mismatch of supply and demand in the economy — and right now, demand continues to outpace supply due to an ongoing global supply chain crunch.

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Much of this has to do with the COVID-19 pandemic, which contributed to a slowdown in production of goods and also clogged up distribution routes. Meanwhile, many consumers became flush with cash because there wasn’t much to spend it on during extended pandemic lockdowns.

Now, with the economy reopening, consumers want to spend that money, but supply can’t keep up. Because the Fed can’t do anything to fix the supply problem, it aims to slow demand through higher benchmark interest rates, which make lending more expensive on everything from cars to mortgages. The idea is that higher mortgage and loan rates will force consumers to cool their spending, bringing supply and demand into greater equilibrium.

Because inflation is so high and resilient this year, the Fed is being particularly aggressive with its interest rate hikes. A one-time increase of 75 basis points is considered aggressive enough. Three in a row is almost unheard of.

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For the near term, at least, that could mean bad news for the economy. Typically, higher interest rates lead to a slower economic growth, which usually translates into higher unemployment, NBC News reported. It cited a Deutsche Bank projection that the U.S. unemployment rate will rise nearly a full percentage point to 4.5% over the next 12 months.

For now, however, the U.S. job market remains strong, and some observers expect it to remain that way for the foreseeable future.

“The labor market remains tight and workers continue to benefit from very favorable job-finding prospects, primarily reflecting the fact that total jobs remain 5.2 million above the total number of workers,” Goldman Sachs chief economist Jan Hatzius wrote in a note earlier this week.

The housing market is another matter. Higher mortgage rates, combined with record home prices, might lead to a significant decline in home sales. As NBC News noted, at least one economist — Ian Shepherdson, chief economist at Pantheon Macroeconomics — recently said the U.S. home market is now in a “deep recession.” He pointed to nine straight declines in the National Association of Home Builders’ index of homebuilder activity and sentiment. He expects the Fed to “dial back the pace of tightening” moving forward.

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Because of higher interest and mortgage rates, many would-be home buyers might decide to hold off until rates go down again, said Michele Raneri, vice president of Financial Services Research and Consulting at TransUnion.

“Those who do choose to buy may be more likely to select an adjustable-rate mortgage because their initial monthly payments will be lower than those they would find with a fixed-rate mortgage,” Raneri said in an email to GOBankingRates.

However, there is at least on positive aspect to higher interest rates — you get better interest on savings accounts.  

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“For folks putting money in accounts, the impact of rates rising means you’re earning more money on what you’re depositing,” Angela Holliday, president of Frost Brokerage Services Inc. and Frost Investment Services LLC, said in email comments sent to GOBankingRates. “Any time the rate increases, you get more return on that money. We see the same impact for fixed investment products.”

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