When the Fed hikes interest rates, who gets hurt?

The Federal Reserve is expected to hike interest rates by 75 basis points for the fourth consecutive day on Wednesday in a bid to cool a hot economy.

Federal Reserve Chair Jerome Powell said in September he wished “there was a painless way” to cut interest rates inflation. “There isn’t,” he said.

So who’s gonna feel the pain?

borrower

In order to lower the overall prices, the federal reserve increases interest rates. The intended effect is to make borrowing more expensive. This may seem counterintuitive: what’s the point of fighting inflation if not reducing consumer costs? But when credit prices rise, consumers become less likely to borrow and therefore spend less. And when consumer spending falls, it puts downward pressure on prices throughout the economy.

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

Home loans are expected to become more expensive (more on that below), but borrowers can also expect higher interest rates on personal loans and auto loans. Small business owners may find it harder to get affordable credit, and that could dampen new businesses, says Brad Hershbein, senior economist and associate research director 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 dull axe.”

local expert

Kathryn Edwards | Economist and Professor at Pardee RAND Graduate School

There are signs that borrowers are taking on more debt than usual. Average personal loan debt is $10,344 in the second quarter of 2022, credit bureau TransUnion found — a 20% increase in average debt since the same point in 2019. Rising interest rates coupled with a vehicle shortage have sent the average car into the Loan balance skyrocketed to more than $20,000, according to July 2022 data from credit bureau Experian.

The combination of higher balances and higher interest rates is making it harder for borrowers to repay: default rates for personal loans hit 3.37% in the second quarter of 2022, data from TransUnion shows. It is the highest crime rate since the pandemic began.

High delinquency rates will likely result in more borrowers defaulting on their debts, leading to a variety of negative consequences such as collection costs, credit damage, property confiscation, and garnished wages.

Home buyers and renters

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

Another worrying sign: Despite their contribution to the housing market crash of 2008, adjustable rate mortgages have once again become popular with homebuyers trying to avoid high fixed interest rates. Borrowers who accept these types of loans risk making unpayable payments if interest rates continue to rise.

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

Data analyzed by the National Association of Realtors shows that blacks have the lowest homeownership rates among racial/ethnic groups. The 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 real estate firm Redfin. But experts say the downward trajectory could reverse as potential first-time homebuyers remain in the rental market.

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

“That could affect economically weaker people,” he says.

retirees and near-retirees

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

Those who have retired, particularly low-income retirees, are somewhat sheltered from rising prices: the most recent 8.7% cost-of-living adjustment for Social Security recipients was the largest increase in 40 years.

But it may not be enough to combat the aftermath of rate hikes.

“Many older, low-income workers have a strong incentive to stop working at age 62 because of the Social Security crisis, while higher-income workers are likely to work much longer,” says Hershbein. In this way, the cost-of-living adjustment could ultimately reduce the pension income of low earners in the long term.

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

  • Drops in 401(k)s and IRAs. Rate hikes usually lead to falling stocks (the S&P 500 is down about 20% from its 2022 peak), which can wreak havoc on retirement accounts.

  • Increased house costs. Retirees with homeowners and adjustable rate mortgages face higher costs.

  • Difficulty downsizing. Retirees looking to sell their homes may have a harder time because of higher interest rates on new mortgages. Likewise, trying to buy a smaller home or entering a costly rental market could be more expensive.

Most retirees have a fixed income, which means higher costs for goods and services make it difficult for them to keep up. That alone could force retirees back into the labor market, but if unemployment rises, re-entering the labor market could be difficult.

low earners and the unemployed

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

“For working Americans, who are already feeling the pressure of inflation, losing jobs will make it much worse,” wrote U.S. Senator Sherrod Brown, D-Ohio, chair of the Banking, Housing and Urban Affairs Committee, in a letter to Powell. “We cannot risk the livelihoods of millions of Americans who cannot afford it.”

Unemployment insurance claims aren’t the best barometer of an impending recession, Edwards and Hershbein agree. Hershbein says to keep an eye on the speed and downward trend in churn rates and job openings.

Higher churn rates signal workers’ ability to move from job to job, a sign of a healthy labor market. A sudden drop in exit rates can be a bad sign, but if they come down gradually, the Fed may just be able to get inflation under control without triggering a recession.

“Even though the Fed is moving as aggressively as it has, it hasn’t crashed yet, but what if they get that calibration wrong?” says Herschbein. “It’s like a pot of boiling water: it looks like it’s going to simmer just fine, then you turn away and the whole thing boils over. That can happen so quickly. That 75-point raise didn’t make a difference, but the next 75-point raise might do it.”

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

But Edwards says it’s possible that in the event of a recession, employers will be less inclined to downsize than they were during the COVID crash, when 22 million Americans lost their jobs.

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

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