The Federal Reserve’s aggressive interest rate hikes this year have triggered a massive stock market sell-off and significantly increased the risk of recession all in the name of bringing down soaring inflation.
But will it work?
Rising rates increase consumer and business borrowing costs, which reduces demand for products and services broadly, leading suppliers to cut prices or stop raising them. But the immediate effect varies significantly across individual goods and services.
“When consumers start to feel those higher interest rates hitting wallets… and when their desire or ability to buy is diminished, you’ll start to see demand ease,” says Katie Thomas, who leads the Kearney Consumer Institute, a think tank that studies consumer behavior.
For instance, some prices, like food, continue to go up in part because demand is so strong, said John Cochrane, a senior fellow at the Hoover Institution. “People are paying those higher prices. If people weren’t paying those higher prices, the prices would go down.”
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What happens when the Fed raises interest rates?
Traditionally, higher interest rates have had the most profound effect on big-ticket purchases like houses, cars and appliances that rely heavily on consumer financing, says Laura Veldkamp, a professor of economics and finance at Columbia University’s Graduate School of Business.
Where higher interest rates may help lower prices:
The Fed's actions should help lower the prices of appliances and furniture. Low and middle-income shoppers frequently finance purchases of living room sets or appliances with in-store financing at rates that can range from zero to upwards of 30%.
As rates rise, some shoppers are likely to turn to less expensive models or forgo purchases altogether, Veldkamp says.
That softer demand should, at least on the margins, help nudge prices lower. But such impacts can take about two years to play out, Veldkamp says.
Home prices should continue to decline as a result of the hikes. The housing market already has significantly weakened because of the Fed’s hiking campaign. The average 30-year mortgage rate has shot up to more than 6% from 3.2% in January. That increases the monthly payment on a typical $312,000 mortgage by nearly $500.
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Existing home sales are down 20% from a year ago as of August and median home prices are down 6% since reaching a record high in June, according to the National Association of Realtors.
Rent should go down as the central bank raises borrowing costs. Wages are up almost 7% compared with a year ago, according to the Atlanta Fed's Wage Growth Tracker. That’s the fastest rise in more than 20 years. That’s allowing producers to pass on more price increases to consumers.
To get inflation under control the Fed needs to slow wage growth, said Omair Sharif, founder of research firm Inflation Insights. The Fed can accomplish that by raising interest rates to a point where it causes employers to slow hiring or lay off workers. That’s already happening in the tech sector.
When hiring demand slows, the wages employers are willing to pay for workers go down and raises are harder to get.
Landlords typically base rental rates off renters’ incomes, which is often a requirement to disclose in a rental application. Last year when applicants’ incomes were higher than those in the prior year, landlords knew they could hike rent, Sharif said.
“If they see income going up 4%, they’re not going to raise rent by 6%,” he added.
Also, lower home prices should spur more renters to buy, easing demand and prices in the rental market, said Kathy Bostjancic, U.S. chief economist at Oxford Economics.
For the first time since December 2020, rents across the country fell by 0.1% in August, according to a report from property data company CoStar Group.
Airfares and hotels
Airfares and hotels should go down as rates go up.
Since these purchases are discretionary, higher credit card rates, along with higher prices, should prompt many consumers to put off expensive trips until rates and borrowing costs come down, Channel and Thomas say.
Where higher interest rates may not help lower prices:
For the most part, the increase or decrease in supplies of goods is outside the Fed’s control. Yet they’re playing a significant part in boosting prices. For instance, nationwide outbreaks of avian flu, which began in February and continue to spread, is causing farmers to kill flocks of chicken. As a result, a carton of eggs is costing consumers nearly 40% more than a year ago.
Here the Fed’s primary tool, raising interest rates, isn’t going to help.
In Cochrane’s view, lawmakers bear a significant amount of blame for the inflation we’re experiencing as a result of doling out $5 trillion in stimulus aid during the pandemic. The aid, which included stimulus checks and enhanced unemployment benefits, successfully gave consumers an appetite to spend money. But because of supply-side problems, producers couldn’t accommodate the spike in demand leading to persistently higher prices, Cochrane argued.
“Congress put the gas pedal on the floor and now they're asking monetary policy to pull on the parking brake. That’s an imperfect way to run the economy.”
Fed rate hikes aren't likely to help lower the price of cars just yet.
New vehicle prices were up 10.1% annually in August, according to the consumer price index. Meanwhile, interest rates on auto loans are the highest in 12 years, according to Bankrate.
But that isn't deterring consumers from buying cars. Sales at motor vehicle and parts dealers rose by 2.8% in August on a monthly basis, according to retail sales data figures published by the Census Bureau.
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Historically, rate hikes have helped bring down car prices because so many consumers need to borrow money to buy a car, said Jacob Channel, senior economist at LendingTree.
But they’ve had a minimal impact on car prices lately since they’ve been overpowered by the effect of ongoing computer chip shortages which have constrained production and resulted in lower vehicle supplies and higher prices, he said..
Fed rate hikes should have a minimal effect on food prices.
Those prices, up 11.4% annually, largely have been propelled higher by supply-chain bottlenecks, higher cost of labor, ingredients and fuel, unfavorable weather and Russia’s war in Ukraine, said William Snell, an agriculture economist at the University of Kentucky.
Consumers have already changed their buying habits as a result of high prices, opting for generic brands, fewer organic produce and meat alternatives, Snell said. But these switches aren’t significant enough to bring down prices, he added.
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Many consumers, of course, do pay for groceries by credit card, whose rates are directly affected by Fed rate moves. Yet since food is a necessity, shoppers are unlikely to stop buying bread or milk because their credit card rate rises, Channel says.
Gas prices won't be very responsive to Fed hikes.
Gasoline prices are mostly determined by oil prices, which are set on a global market, Veldkamp says. Still, Americans have driven less since U.S. gas prices peaked at about $5 in June, helping lower pump prices by about 20%.
Like food, even though consumers often pay for gas with a credit card, rate increases aren’t likely to cause them to cut back on gas, Veldkamp says.
This article originally appeared on USA TODAY: Interest rates: When Fed raises them, some costs won't go down