The Federal Reserve’s rate hike last week did more than raise the overnight rate paid on funds held by banks at the central bank. It also reshaped expectations among companies, consumers and financial markets. Higher rates affect borrowing costs, but they also influence decisions about inflation, saving and future economic activity—decisions that can ultimately feed back into the economy.
The Fed is trying to change economic behavior
Economic activity is driven in large part by incentives and behavior. For the Federal Reserve, changing interest rates is not merely a technical adjustment. It is a way to influence household and corporate decisions by changing the cost of financing, the return on savings and expectations for the path of the economy.
After the 2008 financial crisis and during the Covid-19 pandemic, the Fed cut rates sharply to reduce borrowing costs and encourage consumption and investment. The effects were not immediate, but over time low rates helped support the recovery in economic activity.
The current environment is more complicated. Unemployment remains low, while inflation is still elevated. The war in Iran has pushed up energy prices, with higher costs spreading through transportation, production and everyday goods and services. At the same time, the debt accumulated by the U.S. government and most other developed economies is adding pressure to market interest rates.
The Fed can directly control the rate it pays banks, but it cannot directly control market expectations. In 2020, the central bank explicitly indicated that it was willing to tolerate higher inflation. That position may have been defensible at the time, but once companies and consumers begin to believe prices will keep rising, they may bring forward purchases, adjust prices and change spending plans. If some businesses raise prices first, others may follow, making inflation expectations harder to reverse.
Higher rates help banks—and raise their funding costs
Higher interest rates generally increase the income banks earn from lending. They can also weaken demand for loans and intensify competition for deposits.
A Credit One Bank survey of 1,000 people found that half of respondents had already moved money. Among those who shifted funds, most cited the opportunity to earn returns of 4% on certificates of deposit or other savings products as an important reason.
That means the impact of higher rates on banks is not one-sided. Loan portfolios may generate more income, but banks also have to pay more to retain depositors. If savers view 4% as an important threshold, banks may be forced to raise deposit rates, limiting the improvement in their margins. For depositors, even relatively small differences in rates can accelerate the movement of cash between banks and savings products.
Bond markets are repricing the global rate path
The United States is not the only economy facing higher rates. Central banks across most developed markets are responding to inflation and energy-price pressures, and investors currently expect a series of additional rate increases.
JPMorgan analyst Bruce Kasman said expectations for the policy path in developed markets had changed significantly since the start of the year. Markets expect the relevant central banks to deliver cumulative rate increases of one percentage point by the middle of next year.
One notable feature of the current cycle is that central banks appear increasingly to be responding to markets rather than setting the direction on their own. Before the Fed’s latest hike, the yield on the 10-year U.S. Treasury note was already approaching 5%. It subsequently moved above that level.
Higher long-term yields typically raise financing costs and weigh on economic activity. In normal circumstances, they can also help ease inflation—the type of policy transmission the Fed wants to see.
But when bond yields move first, a central bank’s decision can appear to be catching up with the market. Investors have already repriced assets to reflect inflation, energy costs, government debt and the global interest-rate outlook. The policy-rate increase then serves partly as confirmation of that repricing, rather than being its starting point.
Inflation expectations remain difficult to manage
Inflation is not simply a mathematical result of the money supply and interest rates. It also reflects how people view future prices. Consumers who expect prices to be higher tomorrow may buy today instead. Businesses that expect costs to continue rising may raise prices earlier or secure raw materials in advance.
Once those expectations become embedded in pricing and consumption decisions, the central bank may need more time to reverse them. That is why the Fed’s communication is almost as important as the rate decision itself.
The policy experience during the tenure of former Fed Chair Jerome Powell showed that a central bank can often transmit policy more effectively when it sets expectations proactively, rather than responding after expectations have already shifted. Kevin Warsh has argued that market participants should retain greater autonomy in making economic decisions. Yet when inflation expectations and rate projections are changing frequently, the Fed’s ability to influence behavior still depends on whether businesses, consumers, banks and investors believe its policy signals.