Why Does the Federal Government Raise Interest Rates?

Federal Reserve Bank officials raised interest rates by 75 basis points last week. This was the third consecutive interest rate hike by the Federal Reserve this year. The US is now experiencing the highest levels of inflation since the 1980s, so more rate hikes are likely to come.

The question many Americans have been asking is “Why does the federal government need to raise interest rates?”

Why does the federal government need to raise interest rates?

When you get a loan from a bank, you pay interest on the money borrowed. Banks also borrow money. Banks pay interest to the individuals who have money on deposit, or they may pay interest to the Federal Reserve if they borrow money from the Federal Reserve to lend to you.

Banks then operate on a spread between the interest they pay and the rate they charge their customers when lending money.

Using the law of supply and demand, if it’s more expensive to borrow money, consumers and corporations will tighten their belts and spend less. Less spending will lead to a decrease in demand, which leads to a decrease in the price of goods and services.

Unfortunately, the process of raising interest rates to keep inflation low is not a simple one. A combination of higher interest rates, high inflation, and slowing economic growth could push the economy into a recession. There is a very fine line that the Federal Reserve must walk, and it becomes increasingly difficult to maintain a healthy economy as interest rates climb.

Does Raising Interest Rates Actually Work?

Paul Vocker, former chairman of the Federal Reserve who helped the Carter administration push back against the Great Inflation of the 1970’s, has called raising interest rates “the only game in town” to fight inflation.

Raising interest rates is a crude tool, but one of very few tools available to the Federal Reserve to lower inflation without passing legislation. In theory, people will begin to avoid purchasing big-ticket items if the cost to finance that item increases too much. As less and less consumers compete for the supply of goods and services, inflation should slow down.

Current Federal Reserve chairman Jerome Powell recognizes this strategy comes with risk: “While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses.”

Federal Reserve Chairman Jerome Powell

In the high-inflationary-environment we find ourselves in, Jerome Powell sees inflation as a bigger threat than the threat of a recession, higher unemployment, or a stock market correction. And he appears ready and willing to sacrifice the later to achieve the former.

So, What’s Next?

Projections indicate another 75 basis-point hike could be on the table for November. In addition to higher interest rates, more rate hikes would likely have a negative impact on both the stock and the bond markets.

As the world waited for the Federal Reserve’s announcement last week, Ray Dalio came out with some strong statements about the state of the US economy and the stock market.

Ray Dalio is the co-chief investment officer of the world's largest hedge fund, Bridgewater Associates. While no one, including Ray Dalio, can predict the future direction of the stock market or the economy, Ray is one of the most successful investors on the planet, and his market observations are worth listening to.

Dalio believes that the Fed must continue to increase interest rates if it has any hope in getting inflation under control. He also believes that stocks and bonds will continue to suffer as the U.S. economy slides into a recession in 2023 or 2024. Ray stated that “a mere increase in rates to about 4.5% would lead to a nearly 20% plunge in equity prices.”

Dalio may be right. We are likely to see more pain as the Federal Reserve seeks to tamp down inflation by raising interest rates, and the higher rates go, the higher the probability of an ensuing recession.

Conclusion

No one has a crystal ball to tell you what is going to happen to the economy or the stock market in the next 6-18 months. Anyone claiming to know exactly what will happen should be avoided.

The best solution is to have a financial plan in place that will withstand rising interest rates, out-of-control inflation, or recessionary environments.

To discuss how to start your plan, schedule a meeting below.

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