The Federal Reserve raised its benchmark interest rate significantly on Wednesday, the latest in a series of hikes aimed at tackling sky-high price increases last seen more than four decades ago.
But rate hikes at the Fed risk widespread financial pain. A rise in the benchmark interest rate raises borrowing costs for consumers and businesses, which should in theory reduce inflation by slowing the economy and sapping demand.
That means borrowers will face higher costs for everything from car loans to credit card and mortgage debt. More alarmingly, the approach risks tipping the economy into recession.
These significant risks, however, come with potential financial benefits, experts told ABC News. First, rising borrowing costs directly benefit savers, who can benefit from increased interest earned on bank accounts, they said.
In addition, the effort to reduce inflation is a financial promise, as lower prices would ease economic hardship and improve purchasing power, especially for low- and middle-income households, they added.
“When interest rates go up and money gets tighter, people can get paid for the money they have on hand in a bank,” James Cox, a financial advisor and managing partner at Harris Financial Group, told ABC News. based in Virginia.
“Many Americans will enjoy having interest in their savings for the first time in many years,” he added.
The string of rate hikes so far this year has led to an increase in interest rates on savings accounts at banks, Greg McBride, chief financial analyst at research firm Bankrate, told ABC News . The best-yielding savings accounts earlier this year peaked at 0.55 percent, now they’re above 2 percent, he said.
Federal Reserve Chairman Jerome Powell takes questions during a news conference following a two-day meeting of the Federal Open Market Committee (FOMC) in Washington, DC on June 15, 2022.
Elizabeth Frantz/Reuters, FILE
“They’re still climbing,” he added. “Another big Fed rate hike this week, which only keeps the bullish momentum going.”
Online banks and small banks, especially, have raised interest rates on savings accounts as they try to win back customers, McBride said. He contrasted these banks with larger brick-and-mortar players, which feel less pressure to raise interest rates in this environment because of their strong market position.
“Online banks are among the most competitive out there,” he said. “That’s where we see banks jumping each other as they continually increase their payouts.”
Undoubtedly, interest rates on savings accounts around 2% are still well below the inflation rate, which stood at 9.1% in June. That means the increasingly strong returns on savings accounts remain sharply undervalued by soaring prices, experts said.
In theory, however, as interest rates rise, inflation should fall and savings accounts should yield better returns, improving their prospects as a financial option, they added.
“A lot of the benefits are illusory at a time when inflation is north of 9 percent,” McBride said. “But savings accounts are on the rise.”
American adults have an average of $62,000 in personal savings, according to a study published by Northwestern Mutual in May. Savings gives many people a considerable cushion and the potential to take advantage of rising savings account interest rates.
But high prices have already affected savings. Average savings have fallen 15% since last year, when they stood at $73,000, Northwestern Mutual found.
In addition to leading to higher yields in savings accounts, the Fed’s rate hikes should deliver lower prices, improving the financial outlook for Americans struggling under the weight of high costs , experts said.
Meanwhile, rate hikes could cause substantial financial damage, they added. As the central bank slows the economy and stifles demand, it could trigger layoffs that put millions out of work and force households to withdraw savings they had set aside.
While the rate hikes at the Fed address the upward pressure that consumer and business demand is putting on prices, the hikes do not address the supply shortage behind some of the cost increases, which due to the disruptions of COVID and the war between Russia and Ukraine. This dynamic could limit the effect of rate hikes and prolong the fall.
Highlighting the limitations of rate hikes, Senator Elizabeth Warren (D-MA) in a Wall Street Journal op-ed on Sunday he called them “largely ineffective against many of the underlying causes of this inflationary spike.”
But the risk of entrenched inflation outweighs the costs of short-term financial pain, said Cox, the managing partner of Harris Financial Group.
“It’s either you raise rates very quickly to reduce the rate of inflation, or inflation becomes anchored in the economy and all your personal savings are eaten away,” he said.
“Unfortunately, it is not without pain,” he added. “But it’s much less painful to take your medicine ahead of time than to let the disease take hold.”