Fed Raises Interest Rates by 0.25% Again

What happened

On May 3, the Federal Reserve raised its benchmark interest rate by 0.25%. It's the third 0.25% rate hike to be implemented this year as the central bank aims to cool inflation.

So what

Inflation has been a problem for consumers since mid-2021. In June 2022, the Consumer Price Index (CPI), which measures changes in the cost of consumer goods and services, was up 9.1% on an annual basis. More recently, the CPI dropped down to 5% annually in March.

But the Fed has made it clear that it wants to see 2% inflation, which the CPI is nowhere close to. The central bank has long held that 2% inflation is conducive to a stable economy. And so the latest rate hike's purpose is to get annual inflation closer to that mark.

In its most recent Federal Open Market Committee statement, the Fed said, "The Committee seeks to achieve maximum employment and inflation at the rate of 2 percent over the longer run. In support of these goals, the Committee decided to raise the target range for the federal funds rate to 5 to 5-1/4 percent."

Now what

The Fed's most recent interest rate hike, which represents 10 consecutive rate hikes since early 2022, brings the federal funds rate -- the rate banks charge each other for short-term borrowing -- to its highest level in over 15 years. But borrowing won't only get more expensive for banks -- it might soon get costlier for consumers as well.

When the Fed raises its benchmark interest rate, it tends to drive the cost of consumer borrowing up on a whole. Borrowers might soon face even higher rates for products that include personal loans, home equity loans, and auto loans.

Higher interest rates could also be a problem for consumers carrying variable-interest debt, since the interest rate on those debts now has the potential to climb. This includes those with credit card and HELOC balances.

On a positive note, the Fed's latest rate hike could lead to even higher interest rates for savings accounts and CDs. In fact, a big reason interest rate hikes are effective at slowing the pace of inflation is that consumers tend to borrow less when loans cost more. They also tend to be more motivated to stockpile extra cash in the bank when savings account and CD rates are generous.

It's going to take a decline in consumer spending to bring inflation down to 2%, where the Fed wants it to be. Unfortunately, a steep decline in spending could be enough to fuel a near-term recession, which is something many financial experts are still warning about.

In fact, the Fed itself said recently that it anticipates a mild recession later on in 2023, so consumers should aim to boost their cash reserves to gear up for a period of economic decline. The good news is that they'll get to earn more money on the cash they stockpile in the bank.