As the Fed starts to hike interest rates, Americans should brace for some pain

Federal Reserve Chairman Jerome Powell has signaled that the central bank will raise its benchmark interest rate by at least one quarter of a percentage point on Wednesday.Win McNamee/Getty

WASHINGTON — The Federal Reserve is set to deliver its initial dose of medicine to treat the fast-spreading economic infection of high inflation, and Americans should brace for the side effects.

Among the possible consequences: higher interest rates on mortgages, credit cards, and auto loans. A drop in 401(k) balances. And a squeeze on the federal government’s ability to respond to emergencies such as the pandemic as payments increase on the huge national debt.

Federal Reserve Chairman Jerome Powell has signaled publicly that the central bank will raise its rock-bottom benchmark interest rate by at least one quarter of a percentage point on Wednesday, the first increase since 2018. Analysts and investors expect a series of similar hikes every couple of months into next year, raising the rate from its current range of between zero and 0.25 percent to as high as about 2.5 percent, which is still historically low.

The Fed aims to force inflation down by reducing spending from consumers and business owners who will find it more expensive to borrow.

“The impact of one quarter-point hike is inconsequential, but the cumulative effect of six to 10 interest rate hikes is a whole different ballgame,” said Greg McBride, chief financial analyst at financial information website Bankrate.com.

The consumer price index jumped 7.9 percent in February compared to a year earlier, the highest rate since 1982, after a spike in oil prices triggered by Russia’s invasion of Ukraine added to already fast-rising prices caused by pandemic supply chain disruptions, pent-up demand, and government spending. High inflation is hitting American families and businesses hard, posing a threat to the strong economic recovery from the pandemic.

Inflation is also a major political problem for President Biden, who declared in his State of the Union address that “my top priority is getting prices under control.” Half of the respondents in a Wall Street Journal poll released Friday ranked inflation as the most important thing that the president and Congress should address, double the second-place issue of the war in Ukraine. And 63 percent of those registered voters in the poll said they disapproved of how Biden is handling inflation.

So there’s a lot at stake economically and politically as the Fed, the federal government’s main inflation fighter, takes its first step in what will be a months-long effort to try to tamp down soaring prices for gas, groceries, cars, rent, and other consumer expenditures.

The Fed’s task is extremely difficult as it must figure out how much to raise rates without slowing the economy so much it falls into recession. Inherent in the effort is some pain for average Americans, whom the Fed is trying to discourage from spending, said Kathy Bostjancic, chief US financial economist at Oxford Economics, a global forecasting and analysis firm.

“You don’t want it to be a fatal blow, but you certainly want it to pinch consumer spending,” she said of the interest rate hikes. “To slow it, not to shut if off completely.”

When the pandemic struck two years ago, the central bank reduced its benchmark federal funds rate to near zero in order to stimulate spending. That rate only directly applies to short-term lending between banks. But banks use it as a benchmark for consumer and business loans, and it also affects longer-term lending, like mortgages.

In anticipation of Wednesday’s Fed hike, mortgage rates already have risen. The average 30-year-fixed-rate loan was 4.42 percent on Tuesday, up more than 1 percentage point since the start of the year to the highest level since 2019, according to Mortgage News Daily.

Credit card interest rates will adjust up within one or two billing statements after the Fed rate hike, McBride said. In the past, banks have also increased the interest rate they pay to customers on their deposits. But major banks are flush with deposits and are unlikely to increase those rates much, if at all, he said. Federally insured online banks, which are more eager for customers, are a better bet to increase their interest rates on savings and checking accounts.

Stock prices are likely to decline because higher interest rates increase borrowing costs for companies and make stocks a less attractive investment. Major stock indexes have already pulled back substantially in anticipation of Fed rate hikes, as well as in reaction to the Ukraine war. McBride said investors should ride out the volatility and avoid panicking because stocks usually rise over the longer term.

“We’ve seen this movie before. After the dotcom bust, after the Great Recession, and even just after the start of the pandemic, markets fell by a third in the early part of 2020 and have since recovered and gone on to set new highs after new highs,” he said. “Don’t try to outguess the market. Play the long game.”

Yields on Treasury bonds have also increased in anticipation of the Fed rate hikes, and that’s a problem for the federal government as it must continue to finance its $30 trillion national debt.

Last July, when many economists thought high inflation would only last a few months, the Congressional Budget Office forecast the US government would pay $306 billion in interest on the debt this year. But that forecast was based on the Fed not raising interest rates until the middle of 2023.

If interest rates go up just 1 percentage point more than forecast over the next decade, Congress will need to find an additional $187 billion per year to pay the additional interest on the debt, according to an analysis by the Committee for a Responsible Federal Budget, a fiscal watchdog group.

Jason Furman, a Harvard economist who served as chairman of the White House Council of Economic Advisers during the Obama administration, said inflation isn’t all bad when it comes to the national debt. It could help ease the burden over time by reducing the amount of debt in relation to the size of the economy.

Overall, Furman said he is not worried the gradual interest rate hikes will significantly disrupt the economy or the United States’ ability to pay off its debt. He noted the Congressional Budget Office forecasts the main Fed rate to rise to 2.6 percent by 2031, which is still historically low.

“The era of super duper low interest rates is coming to an end, but we may be in the era of super low interest rates for a while,” Furman said.

But after the federal government doled out trillions of dollars in pandemic relief on top of its massive debt, any interest rate hikes could make it more difficult for Congress and the White House to fund national priorities and respond to future emergencies.

“The Great Recession and the pandemic were absolutely times we should have borrowed. That was the right thing to do” said Maya MacGuineas, president of the Committee for a Responsible Federal Budget. But the federal government kept running large budget deficits when the economy was relatively strong between those two efforts.

Now, the ballooning interest payments on the national debt will constrain Congress and the White House from providing fiscal stimulus if the Fed’s inflation fighting efforts push the economy close to recession, MacGuineas said.

“There was kind of a foolish naiveté of people claiming the past few years, ‘Don’t worry, we can borrow because interest rates will never go up,’ “ she said. “Never is a long time. And now never is here.”