What Happens When the Federal Reserve Raises Interest Rates?

It's important to know how rate hikes impact you.

It's hardly a secret that inflation has been a problem in the U.S. for more than a year. And you may have heard that the Federal Reserve has been raising interest rates in an effort to solve it.

The Federal Reserve raised interest rates seven times in 2022. And we may be in for a similar number of rate hikes this year.

But what exactly do interest rate hikes do? And why should consumers care about them? Let's dive in.

What we mean when we talk about rate hikes

One point of confusion that tends to arise with regard to the Federal Reserve is that it has the ability to dictate how much interest different lenders and credit card companies charge consumers. That's not what the Fed does.

The Fed's job, in a nutshell, is to manage monetary policy for the U.S. and help promote a stable, healthy economy. And the Fed can raise and lower interest rates to achieve this goal.

But when we talk about the Fed raising interest rates, we're not talking about the rates charged for products like personal loans or auto loans. Rather, we're talking about the federal funds rate.

The federal funds rate is what banks charge each other for short-term borrowing. But when the federal funds rate increases, it tends to lead to an uptick in consumer borrowing rates (and also, the rates businesses pay to borrow money).

How rate hikes tie into inflation

Inflation is a result of an excess in consumer demand relative to supply. For inflation to slow, supply needs to catch up with demand, and demand needs to wane. And higher borrowing rates tend to lead to the latter.

When it becomes more expensive to finance large purchases, consumers tend to make fewer large purchases. And as spending declines, the gap between supply and demand can narrow.

What’s more, rate hikes on the part of the Federal Reserve tend to lead to higher interest rates for banking products like savings accounts. And consumers are often more motivated to spend less and save more during periods when banks are paying generously, since they can earn more interest on their money. So that's another way rate hikes can help combat inflation.

Why you need to pay attention to rate hikes

Although the Fed won't dictate what interest rate you're offered when you apply for a mortgage loan or go to finance a car purchase, rate hikes can generally influence the cost of borrowing. So right now, for example, if there's a major purchase on your radar, you may want to hold off on making it if it's not an emergency since the cost of borrowing is up.

On the other hand, if you have extra money, you may want to look at saving it to earn some extra interest. Banks are paying far more interest than they were a year ago, so you have a prime opportunity to earn more on your savings. And then, you can use that money to fund different purchases so you aren't forced to borrow at an expensive rate.