Impact of Federal Reserve Interest Rate Changes

Interest Rates Affect the Ability of Consumers and Businesses To Access Credit

Fact checked by Kirsten Rohrs Schmitt
Reviewed by Robert C. Kelly

The Federal Reserve, often simply called “the Fed,” is the central bank of the U.S. As a key player in shaping monetary policy, its most potent tool is the ability to influence interest rates. But why does the Fed choose to cut rates when economic troubles arise?

The Fed’s straightforward monetary theory is that cutting rates makes it cheaper to borrow money, prompting businesses to take out loans to hire more people and expand production. This, in turn, stimulates economic activity and growth. Conversely, when the economy is moving too quickly, the Fed may raise rates to slow things down and prevent inflation from spiraling out of control.

When interest rates change, there are real-world effects on how consumers and businesses can access credit and plan their finances. These changes ripple through the economy, affecting everything from mortgage rates to stock prices and even some life insurance policies.

Key Takeaways

• Central banks cut interest rates when the economy slows down to encourage economic activity and growth.
• The Federal Reserve (Fed) raises rates when prices are rising to limit inflation.
• The goal of cutting rates is to reduce the cost of borrowing so that people and companies are more willing to invest and spend.
• Interest rate changes spill over to mortgage rates, home sales, consumer credit, consumption, and the stock market.
• Interest rates and inflation have an inverse relationship, which means that low rates lead to high inflation.

Interest Rates and Borrowing

Lower interest rates directly impact the bond market. When the Fed cuts rates, yields on everything from U.S. Treasurys to corporate bonds tend to fall, making them less attractive to new investors. Bond prices move inversely to interest rates, so as interest rates fall, the price of existing bonds rises.

The effects on bonds depend on the type:

1. Government bonds: These are highly sensitive to interest rate changes. When rates fall, government bond prices typically rise the most, as they are considered the safest investments.
2. Corporate bonds: These are also affected, but the impact can vary based on the creditworthiness of the issuing company. High-quality (investment-grade) corporate bonds tend to follow government bonds more closely than lower-quality (high-yield) bonds.
3. Municipal bonds: These are affected like corporate bonds but may also be influenced by local economic conditions and tax considerations.

An increase in interest rates sends the price of bonds lower, negatively impacting fixed-income investors. As rates rise, people are also less likely to borrow or refinance debt since it is more expensive.

The Prime Rate 

A Fed rate hike immediately fuels a jump in the prime rate, which the Fed calls the Bank Prime Loan Rate. This is the rate that banks extend to their most credit-worthy customers.

This rate is the basis of other forms of consumer credit, since a higher prime rate means that banks will increase borrowing costs to account for the risk of less creditworthy companies and consumers.

The prime rate typically changes quickly in response to Fed rate changes, often within hours or days. Most banks adjust their prime rate in unison following a Fed announcement. While the Fed doesn’t directly set the prime rate, changes to the federal funds rate are passed through almost immediately.

Historically, the prime rate has changed as frequently as the Fed adjusts its target rate, which can be several times a year during periods of economic volatility or remain steady for months or even years during periods of stability.

For example, when the Federal Reserve cut the Fed funds rate by 50 basis points to a range of 4.75% to 5% on Sept. 18, 2024, it warranted major news coverage across the U.S., since it hadn’t cut the rate at all in the previous four years. The Fed shifted its strategy during the post-pandemic period, reducing borrowing costs to reignite the markets as employment started to slump.

Credit Card Rates

Working off the prime rate, banks determine how creditworthy borrowers are based on their risk profile. Rates are affected for credit cards and other loans because both require extensive risk-profiling of consumers seeking credit to make purchases. Short-term borrowing will have higher rates than long-term loans.

Variable-rate credit cards are directly tied to the prime rate. When the Fed raises or lowers rates, the prime rate changes, and variable-rate credit cards typically adjust their rates within one or two billing cycles. This means that cardholders can see their interest charges increase or decrease relatively quickly.

Savings 

Money market and certificate of deposit (CD) rates increase because of the uptick of the prime rate. In theory, that should boost savings among consumers and businesses because they can generate a higher return on their savings.

Meanwhile, those with debts would shift their funds to pay them off since those are likely climbing higher than the rates they can get from such financial products.

Traditional savings vehicles like bank accounts and CDs offer minimal returns in a low-interest-rate environment. This can push investors toward riskier assets in search of higher yields. For example, investors might turn to high-yield bonds, dividend-paying stocks, or real estate investments. While these can offer better returns, they also come with increased risk.

U.S. National Debt 

A hike in interest rates boosts the borrowing costs for the U.S. government, fueling an increase in the national debt and increasing budget deficits. According to the Committee for a Responsible Federal Budget, the estimated total budget deficit from 2022 to 2031 will be $12.7 trillion. Increasing rates by just half a percentage point would increase the deficit by $1 trillion.

National debt as a percentage of GDP is expected to be 107.5% in 2031. If rates were 50 basis points higher, this would increase to 110.6% of GDP.

Business Profits

When interest rates rise, it’s usually good news for the banks, since they can earn more money on the dollars that they lend out. But for the rest of the global business sector, a rate hike cuts into profitability.

That’s because the cost of capital required to expand goes higher. That could be terrible news for a market that is currently in an earnings recession. Lowering interest rates should be a boost to many businesses’ profits as they can obtain capital with cheaper financing and make investments in their operations for a lower cost.

Auto Loan Rates

Auto companies benefited immensely from the Fed’s zero-interest-rate policy, but rising benchmark rates will have an incremental impact. In theory, lower interest rates on auto loans should encourage car purchases, but these big-ticket items may not be as sensitive as short-term loans, like credit cards.

Mortgage Rates

A rate hike can send home borrowers rushing to close on a deal for a fixed loan rate on a new home. But mortgage rates traditionally fluctuate more in tandem with the yield of domestic 10-year Treasury notes, which are largely affected by interest rates. Therefore, if interest rates go down, mortgage rates will also go down. Lower mortgage rates mean it becomes cheaper to buy a home.

Home Sales

Higher interest rates and higher inflation typically cool demand in the housing sector. For example, on a 30-year loan at 4.65%, homebuyers can anticipate at least 60% in interest payments over the duration of their investment.

But if interest rates fall, the same home for the same purchase price will result in lower monthly payments and less total interest paid over the life of the mortgage. As mortgage rates fall, the same home becomes more affordable—and so buyers should be more eager to make purchases.

Important

The federal funds rate influences the prime rate, which influences all other interest rates, such as the rates on mortgages and personal loans.

Consumer Spending

A rise in borrowing costs traditionally weighs on consumer spending. Both higher credit card rates and higher savings rates due to better bank rates provide fuel for a downturn in consumer impulse purchasing. When interest rates go down, consumers can buy on credit at a lower cost. This can apply to anything from credit card purchases to appliances purchased on store credit to cars with loans.

Inflation

Inflation is when the general prices of goods and services rise in an economy, which may be caused by a nation’s currency losing value or by an economy becoming over-heated—i.e. growing so fast that demand for goods is outpacing supply and driving up prices.

When prices rise, the central bank often increases borrowing rates to keep inflation in check (they tend to target 2% a year of inflation). When interest rates fall, inflation can increase as people begin bidding up prices once again.

The Stock Market

Although profitability on a broader scale can slip when interest rates rise, an uptick is typically good for companies that do the bulk of their business in the United States. That is because local products become more attractive due to the stronger U.S. dollar.

That rising dollar has a negative effect on companies that do a significant amount of business on the international markets. As the U.S. dollar rises—bolstered by higher interest rates—against foreign currencies, companies abroad see their sales decline in real terms.

Companies like Microsoft, Hershey, Caterpillar, and Johnson&Johnson have all, at one point, warned about the impact of the rising dollar on their profitability. Rate hikes tend to be particularly positive for the financial sector. Bank stocks tend to perform favorably in times of rising interest rates. 

Although the relationship between interest rates and the stock market is fairly indirect, the two tend to move in opposite directions. When the Fed cuts interest rates, it causes the stock market to go up. When the Fed raises interest rates, it causes the stock market as a whole to go down. But there is no guarantee of how the market will react to any given interest rate change the Fed chooses to make.

How Will I Use This in Real Life?

If you ever take out a mortgage, use a credit card, or simply put your money in a savings account, the interest rate is largely determined by the Federal Reserve. The central bank sets the cost of borrowing between banks, and that cost forms the basis of consumer loans such as mortgages, auto loans, and credit cards.

The Federal Reserve lowers interest rates when it wants the economy to speed up, and raises them to slow the economy down. When interest rates are low, you might use your credit card more often, since the payments will be lower. That increased activity tends to raise prices, though. The Fed raises rates when prices grow too fast, discouraging people from borrowing money.

What Is the Overall Effect of Interest Rate Changes?

As interest rates increase, the cost of borrowing money becomes more expensive. This makes buying certain goods and services, such as homes and cars, more costly. This in turn causes consumers to spend less, which reduces the demand for goods and services. If the demand for goods and services decreases, businesses cut back on production, laying off workers, which increases unemployment. Overall, an increase in interest rates slows down the economy. Decreases in interest rates have the opposite effect.

How Do Interest Rate Increases Affect Inflation?

Increases in interest rates cause a decrease in inflation. When interest rates increase, this causes goods and services to become more expensive because borrowing money becomes more expensive. The cost of a house or car will increase if the interest rate is higher. This causes consumers to spend less, reducing the demand for goods and services. When demand decreases, prices decrease too, which reduces inflation.

Who Controls Interest Rates?

A nation’s central bank controls interest rates. Adjusting interest rates to spur or slow down the economy is part of monetary policy, which a central bank is responsible for. Governments are responsible for fiscal policy, which involves adjusting taxes.

The Bottom Line

When the economy falters, the central bank can step in to cut rates. The Federal Reserve is keen to react to rising inflation or a recession using this tool to lower the cost of borrowing so that firms and households can spend more and invest.