The economy runs like a machine. Right now, it’s overheating: Inflation levels are at the highest in decades, with prices climbing on everything from groceries to cars to rent. And the job market is unsustainably tight, with nearly twice as many open jobs as people looking for work.
Normally, the financial system, consumer spending, and business activity keep the hardware running. But at times, those cogs cause glitches or kick into overdrive, and the sprawling apparatus needs to be slowed down.
Enter the Federal Reserve, which has been aggressively raising interest rates — the central bank’s one major tool to lower inflation, curb demand for goods and services, and slow the economy. We won’t know until later if the Fed has been successful — or if it’s forced the economic machine to slow down too much, causing a recession.
The financial system
The financial system includes everything from the stock market to the banking sector to the wonky, technical products that make up the plumbing of the global economy. Changes in the federal funds rate influence those markets in the United States and abroad.
Bond traders, Wall Street bankers, and market analysts all try to anticipate the Fed’s next moves. That amplifies the effect of interest rate increases and the central bank’s public messaging. Analysts might scrutinize Fed speeches in hopes of gleaning any hints on the exact size of the next interest rate hike, so the markets can start pricing in those moves ahead of time. The value of some financial instruments is also influenced by changes in the Fed’s overnight rate.
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Stocks and bonds
Central bankers aren’t specifically aiming to cool stock prices or asset valuations. But their decisions still sway the stock market.
When rates go up, it becomes more expensive for businesses to borrow money. That can hurt future growth and weigh on a company’s stock performance. If enough companies see their stock prices go down, the whole market can sink. And as rates go up, risky stocks can seem less attractive because investors can make more money in safer assets than they can with low-interest rates.
Meanwhile, bonds and interest rates have an inverse relationship. If interest rates go up, bond prices fall, and vice versa. Many bonds pay a fixed interest rate that’s more desirable if interest rates are going down, since the demand for bonds usually rises then, along with their price.
Fed officials often say “tighter financial conditions” aimed at slowing down the economy are among the intended goals of interest rate hikes. That extends to credit spreads, equity prices and the strength of the U.S. dollar, all of which respond to higher interest rates.
But tighter financial conditions can also create spillovers elsewhere. As other countries combat inflation, their currencies may be weaker compared to the dollar, which makes that fight harder.
If higher interest rates drive stock prices down, that can crunch your retirement savings and other investments, though money market and bank savings accounts will probably earn more than they did before.
If a recession happens, it won’t last forever. Experts say that even in times of economic stress, people shouldn’t try to time the market or drain their investments. But your retirement account could take a hit while the Fed’s actions take effect.
For much of the pandemic, there’s been a shortage of new and used cars. Factories around the world have been hammered by chip shortages that limit the number of models available on the showroom floor. But demand has stayed high, with more people shopping for vehicles despite higher prices or longer wait times.
The Fed can’t fix holes in supply chains, but it can make auto loans more expensive — so fewer people will buy cars until supply chains catch up.
The housing market boomed during the pandemic when the Fed’s rates were near zero and people clamored for new homes. Now, the Fed is trying to cool buyer demand to get prices back under control.
In late March, the average rate for a 30-year fixed mortgage, the most popular home loan in the United States, was below 4 percent. In late October, it topped 7 percent.
And already, buyers are bowing out of the market, more homes are available for sale and prices are starting to ease. But the higher loan rates mean many people — especially first-time buyers who don’t have equity to tap for purchases — still can’t afford to buy homes, further crowding the rental market.
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If house payments or auto loans get more expensive as borrowing costs go up, people might cut spending elsewhere.
They might eat out less at their favorite restaurant, put off home renovations or skip a vacation. Those decisions amount to lower consumer demand, with repercussions for the broader economy. That restaurant might cut its hours. That contractor might not have enough cash for new equipment. That hotel might downsize its staff.
Business and industry
Growing a company requires investment, whether hiring new staff, adding a new location or finding new ways to advertise a brand. But when investment costs go up, growth slows down.
Some pockets of the economy are already feeling a slowdown, even though the labor market overall and corporate earnings remain solid. Mortgage lenders, including at major banks, have let go of employees as demand for new loans slows. Job cuts are sweeping through Silicon Valley. Businesses that are attached to the housing market or tourism may be wary of expanding until they have a better sense of where the economy is headed — and if a recession is around the corner.
Investing to grow
The exact interest rate a business pays to borrow from a bank will depend on the type of loan, the company’s financial history, and its relationship with a lender. But regardless of the specifics, higher interest rates from the Fed make borrowing costlier.
A farm may decide against buying new equipment. A start-up may institute a hiring freeze. Businesses may be discouraged from putting more money into investments until they know how they will fare if job growth stalls, consumer spending falls or the economy officially enters a recession.
Higher interest rates make a lot of routine business more expensive for firms that rely on lines of credit or loans. Raising capital also becomes harder when interest rates go up. That can hold back expectations for earnings and future growth, or make investors lose confidence that a company can weather economic stress.
Slimmer profit margins — or no profits at all — might push a company to reevaluate its budget, possibly minimizing staff, cutting back on inventory or shuttering whole departments. It might have no choice but to offset tighter margins by raising prices or eliminating bonuses or salary bumps.
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As interest rates climb, more businesses might see a drop-off in demand, or run out of ways to offset their own rising prices, and they may have no choice but to slow hiring. Already, job postings are falling, and big-name tech companies such as Meta, Intel and Google have implemented temporary hiring freezes for certain roles.
Zoom out, and you’ll see how the Fed aims to slow down the economy from top to bottom.
It could be months before it’s clear how the Fed’s moves have affected the economy. By then, though, it could be too late: A growing number of economists warn that the Fed risks overcorrecting and that its rate hikes are quickly outrunning its ability to see how its policies will work.
But for now, the Fed isn’t letting up. What happens next — for every single cog of the economy’s grand machine — remains to be seen.