Does raising interest rates slow economy?
In short: The Federal Reserve raises interest rates to slow the economy. By making it more costly to borrow and spend, rate hikes discourage borrowing and spending. This lowered demand theoretically slows inflation.
“As the Fed raises interest rates, we typically expect slower economic growth,” says Eric Freedman, chief investment officer, U.S. Bank Wealth Management. Surprisingly, however, Gross Domestic Product (GDP) grew more quickly in 2023 (2.5%) than it did in 2022 (1.9%).
Whenever the Federal Reserve lifts rates to battle high inflation, the risk of a recession increases, and the US economy has typically fallen into an economic downturn under the weight of rising borrowing costs.
The financial sector generally experiences increased profitability during periods of high-interest rates. This is primarily because banks and financial institutions earn more from the spread between the interest they pay on deposits and the interest they charge on loans.
How does raising interest rates help inflation? The Fed raises interest rates to slow the amount of money circulating through the economy and drive down aggregate demand. With higher interest rates, there will be lower demand for goods and services, and the prices for those goods and services should fall.
Inflation allows borrowers to pay lenders back with money worth less than when it was originally borrowed, which benefits borrowers. When inflation causes higher prices, the demand for credit increases, raising interest rates, which benefits lenders.
Low interest rates mean more spending money in consumers' pockets. That also means they may be willing to make larger purchases and will borrow more, which spurs demand for household goods. This is an added benefit to financial institutions because banks are able to lend more.
Higher interest rates tend to negatively affect earnings and stock prices (often with the exception of the financial sector). Changes in the interest rate tend to impact the stock market quickly but often have a lagged effect on other key economic sectors such as mortgages and auto loans.
But sometimes inflation pressures still prove persistent and require ever-higher rates to tame. The result — steadily more expensive loans — can force companies to cancel new ventures and cut jobs and consumers to reduce spending. It all adds up to a recipe for recession.
The Fed may wait too long to cut interest rates and spark a recession, economists say. As inflation gathered force in 2021 and 2022, the Federal Reserve notoriously waited too long to raise interest rates, allowing consumer prices to continue to climb sharply, Fed officials now acknowledge.
What sector will boom in 2024?
- Health care.
- Real estate.
- Materials.
- Energy.
When the central bank increases interest rates, borrowing becomes more expensive. In this environment, both consumers and businesses might think twice about taking out loans for major purchases or investments. This slows down spending, typically lowering overall demand and hopefully reducing inflation.
The larger goal of the Fed raising interest rates is to slow economic activity, but not by too much. When rates increase, meaning it becomes more expensive to borrow money, consumers react by refraining from making large purchases and pulling back their spending.
With profit margins that actually expand as rates climb, entities like banks, insurance companies, brokerage firms, and money managers generally benefit from higher interest rates. Central bank monetary policies and the Fed's reserver ratio requirements also impact banking sector performance.
High-yield savings accounts reward you with a higher interest rate than traditional savings accounts, making your money grow faster as it sits in your account. The interest rate that these accounts offer is noted as APY, or annual percentage yield. The higher your APY, the faster your money grows.
Preferred stocks are not the same thing as bonds, but they are income securities and share characteristics that make them attractive when rates are falling. Specifically, they have an inverse relationship with the general direction of rates, meaning, like bonds, preferred stocks generally go up when rates fall.
Low-income households most stressed by inflation
Prior research suggests that inflation hits low-income households hardest for several reasons. They spend more of their income on necessities such as food, gas and rent—categories with greater-than-average inflation rates—leaving few ways to reduce spending .
Some of the worst investments during high inflation are retail, technology, and durable goods because spending in these areas tends to drop.
Hence, when market interest rates fall, banks' funding costs usually fall more quickly than their interest income, and net interest margins rise. Over time, however, net interest margins fall as loans are repaid or renewed at lower interest rates.
In a similar way, low interest rates encourage consumers to spend more money. Like businesses, they too have an easier time borrowing to finance such purchases as houses and automobiles. In addition, low interest rates act to discourage saving since the amount earned on savings (the interest income) is reduced.
What industries are most affected by interest rates?
The financial industry, consumer staples, healthcare and construction are all sectors that can be positively impacted by rising interest rates.
The Federal Reserve's current rate-hike cycle, which began in March 2022, has pushed interest rates to levels not seen since 2007. That's welcome news to those looking to earn meaningful returns from bonds and cash but can hurt those needing to borrow for big-ticket items, like cars, college, or housing.
Signs that can indicate a healthy economy include low unemployment, a steady growth of inflation, increases in new home construction, optimism measured by the consumer confidence index, and an increasing gross domestic product (GDP).
The U.S. economy appears to have achieved a “soft landing,” with the latest data showing cooling, but still-robust growth. From here, markets seem to expect a powerful rebound in growth and corporate profits supporting strong equity returns.
Not every monetary tightening has resulted in a recession. Fed Chair Jerome Powell has pointed to soft landings after monetary tightening in 1965, 1984, and 1994. Those episodes were arguably less challenging than the current one, however.
