The U.S. central bank last raised its benchmark interest rate by three-quarters of a percentage point, the biggest hike since 1994.
This follows the Fed’s decision to raise its rate by half a percentage point in May, the biggest increase in 22 years.
The Fed is expected to announce another three-quarter point rate hike at 2 p.m. Wednesday.
The fact that the Fed is moving decisively shows confidence in the health of the labor market. But the speed at which interest rates are expected to rise underscores its growing concern over the soaring cost of living.
High inflation will likely force the Fed to raise interest rates several times over the next few months. Fed officials may even resort to large additional rate hikes in an effort to calm inflation.
Americans will experience this policy change initially through higher borrowing costs: it is no longer incredibly cheap to take out mortgages or car loans. And the money that is in bank accounts will finally bring in something, but not much.
The Fed speeds up or slows down the economy by moving interest rates up or down. When the pandemic hit, the Fed made borrowing almost free in an effort to encourage household and business spending. To further stimulate the Covid-ravaged economy, the US central bank also printed trillions of dollars under a program known as quantitative easing. And when credit markets froze in March 2020, the Fed rolled out emergency credit facilities to stave off a financial meltdown.
The Fed bailout worked. There was no financial crisis linked to Covid. Vaccines and massive congressional spending paved the way for a rapid recovery. However, its emergency actions – and their late termination – have also contributed to the overheating of the current economy.
The risk is that the Fed will overdo it, slowing the economy so much that it accidentally triggers a recession that drives up unemployment.
Borrowing costs are rising
Every time the Fed raises rates, it becomes more expensive to borrow. This means higher interest charges for mortgages, home equity lines of credit, credit cards, student debt and car loans. Business loans will also become more expensive, for large and small businesses.
The most tangible way this is manifesting is with mortgages, where rate hikes have already pushed rates up and slowed selling activity.
How high will the rates go?
Investors expect the Fed to raise the top of its target range to at least 3.75% by the end of the year, from 1% today.
For context, the Fed raised rates to 2.37% at the height of the last rate hike cycle at the end of 2018. Prior to the Great Recession of 2007-2009, Fed rates hit 5.25 %.
And in the 1980s, the Fed under Paul Volcker raised interest rates to unprecedented levels to fight runaway inflation. At the peak in July 1981, the effective federal funds rate exceeded 22%. (Borrowing costs will no longer be near these levels and are hardly expected to rise as sharply.)
Nevertheless, the impact on borrowing costs over the next few months will mainly depend on the pace, still undetermined, of the Fed’s rate hikes.
Good news for savers
The floor rates penalized savers. Money hidden in savings, certificates of deposit (CDs) and money market accounts gained next to nothing during Covid (and for much of the past 14 years, for that matter). Compared to inflation, savers lost money.
The good news, however, is that these savings rates will rise as the Fed raises interest rates. Savers will start earning interest again.
But it takes time to play out. In many cases, especially with traditional accounts at large banks, the impact will not be felt overnight.
And even after several rate hikes, savings rates will still be very low, below inflation and expected stock market returns.
Markets will have to adapt
The Fed’s free money has been amazing for the stock market.
Zero percent interest rates drive down government bond rates, essentially forcing investors to bet on riskier assets like stocks. (Wall Street even has a phrase for it: TINA, which means “there is no alternative.”)
Rising rates were a major challenge for the stock market, which had get used to – if not addicted to – easy money.
At a minimum, the rate hikes mean the stock market will face more competition going forward from boring government bonds.
The objective of the Fed’s interest rate hikes is to control inflation while preserving the recovery of the labor market.
Economists warn inflation could worsen further as gas prices have continued to hit record highs in recent days, worsening a spike that began after Russia invaded Ukraine.
Everything from food and energy to metals has become more expensive.
Still, it will take time for the Fed’s interest rate hikes to begin to reduce inflation. And even then, inflation will still be subject to developments in the war in Ukraine, the supply chain mess and, of course, Covid.
CNN’s Kate Trafecante contributed to this report.