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When the Fed raises interest rates, who gets hurt?

The Federal Reserve is expected to raise interest rates by 75 basis points on Wednesday for the fourth consecutive time in its effort to cool a booming economy.

Federal Reserve Chairman Jerome Powell said in September that he wished “there was a painless way” to lower inflation. “There isn’t,” he said.

So who will feel the pain?

Borrowers

To lower overall prices, the Federal Reserve increases interest rates. The desired effect is to make the loan more expensive. This may seem counter-intuitive: what good is fighting inflation if not to reduce consumer costs? But when the price of credit rises, consumers become less likely to borrow, and therefore to spend. And when consumer spending declines, that puts downward pressure on prices across the economy.

The Fed’s approach “has the delicacy of a blunt axe,” says Kathryn Edwards, an economist and professor at Pardee RAND Graduate School. But raising the price of credit is one of the only tools the Fed has to fight inflation.

Home loans are expected to get more expensive (more on this below), but borrowers can also expect higher rates on personal loans and auto loans. It could be harder for small business owners to get affordable loans, which could put a brake on new businesses, says Brad Hershbein, senior economist and deputy director of research at the WE UpJohn Institute for Employment Research. And the most vulnerable borrowers could also face even higher than usual payday loan costs.

The Fed’s approach “has the delicacy of a blunt axe.”

Field expert

Katherine Edwards | economist and professor at Pardee RAND Graduate School

There are signs that borrowers are taking on more debt than usual. The average personal loan debt held is $10,344, as of the second quarter of 2022, according to credit bureau TransUnion – that’s a 20% increase in average debt since the same period in 2019. Interest coupled with a shortage of vehicles pushed the auto loan balance over $20,000, according to July 2022 data from credit bureau Experian.

The combination of higher balances and higher rates is making repayment harder for borrowers: Personal loan default rates hit 3.37% in the second quarter of 2022, according to TransUnion data. This is the highest crime rate since the start of the pandemic.

High delinquency rates will likely lead to more borrowers defaulting, leading to a host of negative consequences such as collection charges, credit damage, asset seizure and wage garnishment .

Home buyers and renters

Mortgage rates on a 30-year loan rose above 7% last week, the highest in 20 years, according to Freddie Mac, a government-sponsored firm that provides capital to the mortgage market.

Another worrying sign: despite their contribution to the housing crash of 2008, adjustable-rate mortgages have become popular again with homebuyers trying to avoid locking in high fixed rates. Borrowers who take out these types of loans risk unaffordable payments if rates continue to rise.

The cost of mortgages will reduce potential borrowers’ ability to buy homes, one of the main ways people build wealth, Edwards says. And the fallout will hit potential first-time home buyers the hardest. Home buyers are predominantly young and black of all ages.

Data analyzed by the National Association of Realtors reveals that black people have the lowest homeownership rates among racial/ethnic groups. His analysis found that black applicants are twice as likely to be denied a mortgage as white applicants.

Meanwhile, rents are showing signs of falling since hitting highs earlier this year, according to data from property firm Redfin. But experts say the downward trend could reverse as potential first-time home buyers remain in the rental market.

Landlords with variable-rate mortgages could also raise rents to offset their increased borrowing costs, Hershbein says.

“It could affect the most economically vulnerable people,” he says.

Retired and near-retired

In 2019, the majority of baby boomers were still working. Then the pandemic hit, forcing many baby boomers into early retirement.

Those who have retired, especially low-income retirees, have some protection against rising prices: the last 8.7% cost-of-living adjustment for Social Security recipients was the biggest increase in 40 years.

But that might not be enough to combat the aftermath of interest rate hikes.

“A lot of lower-income older workers, because of the Social Security hike, have a strong incentive to stop working at age 62, while higher-income workers will likely end up working much longer,” Hershbein says. In this way, the cost-of-living adjustment could ultimately reduce the retirement income of long-term low-income workers.

Rate hikes could make it harder for older Americans to retire and for current retirees to stay in retirement. Here’s why:

  • Dive into 401(k)s and IRAs. Interest rate hikes typically cause stocks to fall (the S&P 500 is down about 20% from its 2022 peak), which can wreak havoc on retirement accounts.

  • Increase in house costs. Retired homeowners with adjustable rate mortgages will have higher costs to pay.

  • Difficulties in downsizing. Retirees who want to sell their homes may find it more difficult to do so due to higher rates on new mortgages. Likewise, it could be more expensive to try to buy a smaller house or to enter an expensive rental market.

Most retirees are on fixed incomes, which means higher costs of goods and services prevent them from keeping up. This alone could force retirees back into the labor market, but if unemployment rises, re-entering the labor market could be difficult.

Low-wage and unemployed workers

So far, interest rate hikes have not caused a recession. And the United States continues to have some of the lowest unemployment rates in history. But all that could change if the Fed continues to raise rates.

“For American workers who are already feeling the crush of inflation, the job losses will make matters worse,” wrote U.S. Senator Sherrod Brown, D-Ohio, chairman of the Banking, Housing and Human Resources Committee. urban affairs, in a letter to Powell. “We cannot risk the livelihoods of millions of Americans who cannot afford it.”

Unemployment insurance claims are not the best barometer of an impending recession, Edwards and Hershbein agree. Hershbein says to keep an eye on the speed and downward trajectory of resignation rates and job postings.

Higher quit rates signal workers’ ability to move between jobs, a sign of a healthy labor market. A sudden drop in quit rates can be a bad sign, but if they drop gradually, the Fed might be able to get inflation under control without triggering a recession.

“Although the Fed has acted so aggressively, it hasn’t caused a crash yet, but what if they get their calibration wrong?” said Hershbein. “It’s like a pot of boiling water: it looks like it’s simmering really well, then you turn away and it boils over. It can happen just as quickly. This 75 point increase did not cause a change, but the next 75 point increase might.

Unemployment during a recession tends to exacerbate perennial labor market problems. Namely, the highest unemployment rates are among low-wage and part-time workers, as well as black workers at all wage levels.

But Edwards says employers may be less inclined to lay off staff in a recession than they were during the COVID crash when 22 million Americans lost their jobs.

“After struggling to hire those 22 million people, they feel like their workforce is less consumable,” Edwards says. “They might prefer not to fire people if they don’t have to.”

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