Riding the Rate Roller Coaster: Is the Fed's Next Stop a Full Halt?

A simple run to the grocery store leaves us all too familiar with the rising costs of inflation. As the leaves change colors this autumn, seemingly, so does the economic climate. Many are aware that raising interest rates are a primary avenue that the Federal Reserve, or the Fed, uses to tame inflation. But the mechanics of this move can be somewhat of a black box. How does it all work? 

In the intricate world of economics, the Federal Reserve wields a powerful wand known as the federal funds rate. The federal funds rate is the interest rate at which banks and credit unions lend reserve balances to other depository institutions overnight. By adjusting this rate, the Fed sets the cost of borrowing money, influencing overall economic activity. However, raising rates doesn’t just combat inflation. It has a wide-ranging effect on the economy in a number of ways. As rates rise, it disincentivizes people from taking out loans and investing in the economy. This is a crucial step in slowing down the economy and preventing ‘overheating’.

The general give-and-take of inflation and interest can be explained via example. One, if not the most, affected sectors from the rising interest rates is the real estate industry. Real Estate is a particularly loan-heavy sector since buyers and investors often finance their purchases of these tangible, high-value assets through loans. When interest rates rise, the cost of borrowing also increases. Many in the housing industry are calling on the Fed to stop raising rates as "mortgage rates have reached their highest level in more than two decades" according to data from Freddie Mac. The burden is further evidenced by the sharp decline in mortgage applications, which have plummeted to their lowest levels since 1996, according to the MBA.

The good news, however, is that the Fed seems to be listening. At its last FOMC (The Federal Open Market Committee) meeting last month, the Fed paused its interest rate hikes for just the second time this year. Many experts in the industry expect one more raise this year followed by pauses or even cuts.

This, however, begs the question: "Is the Fed stopping its rate hikes too early?" While continuing to raise interest rates would upset many and hurt the economy in the short term, there just simply doesn't seem to be enough evidence to stop the rate hikes. Employment and inflation are still too high and continue to rise. In such a scenario, classic economic theory dictates a further tightening of monetary policy via raising interest rates to prevent overheating.

But why should we care if the economy overheats?

If interest rates are cut too early and the economy overheats, it can lead to bankruptcies, large job losses, wage cuts, and an overall weak economy. Just take a look at the years leading up to the “Great Recession” in 2008. Due to a housing market bubble, risky lending practices, and the widespread securitization of subprime mortgages, the economy overheated and led to the worst recession since the Great Depression. A premature halt in raising interest rates could saturate the market with cheap credit and lead to reckless investments, thus creating an economic “bubble.” When this bubble bursts, the fallout isn't just numbers on a spreadsheet, it's families thrown into financial turmoil, and an economy thrown in the gutter. Simply put, if the Fed cuts rates too early, there’s a good chance that they won’t be able to fix it until it's too late. 

So, what's the best path forward? In the months ahead, as the Fed potentially draws the curtain on its era of rate hikes, the decision will undoubtedly be debated. As we ride this interest rates roller coaster with its dizzying highs and lows, the decisions made at the next juncture will be critical. The next FOMC meeting is right around the corner from October 31st-November 1st. I encourage you to pay attention. The choices of today will shape the economic landscape of tomorrow. 

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Photo Caption: The interest rate roller coaster has a real an impact on your wallet and the economy

Photo Credit: Markus Spiske / Unsplash