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How do interest rates work?

Already this year, the Federal Reserve (Fed) has raised interest rates four times, with more rate hikes planned through 2022 and 2023. As America’s central bank, one of the roles of the Fed is stabilizing and stimulating the economy. One of the tools the Fed uses to do this is raising interest rates when the economy is stronger—making money more expensive to borrow—and lowering interest rates in slower economies.

Why is the Fed raising interest rates now?

At the start of the pandemic in 2020, as people were losing jobs and businesses were closing doors, the Fed slashed interest rates to between 0 and .25% to encourage spending and keep the economy afloat. “Most consumers and companies have emerged from the pandemic with relative financial strength, given the quick initial action from the Fed,” explains Steve Lowe, vice president and chief investment strategist for Thrivent. “Unfortunately, the Fed probably waited too long to address inflation and must now raise interest rates in an attempt to curb inflation.”

How does this translate to interest rates on banking products like mortgages, consumer loans & savings accounts?

The Federal Reserve’s decision to continue to increase the federal fund rate, which is used by investors to track the cost of borrowing between banks and other depository institutions, indirectly affects the rates that can be offered under the different banking products, says Luis Gonzalez, a senior secondary marketing analyst for Thrivent Federal Credit Union.

“For instance, even though fixed mortgage rates are not set by the Fed, they tend to track 10-year U.S. Treasury bonds, which are in turn impacted when there is an increase or decrease of the fund rate,” Gonzalez says. While the Fed’s decision to increase the federal fund rate will impact consumers’ ability to borrow on banking products, such as consumer loans, credit cards, mortgages, etc., it also will allow for a higher yield for the consumers’ benefit on banking products such as savings accounts, money market accounts and CDs.

What does raising the rates mean for home buyers?

If you have a fixed-interest-rate loan already in place, the Fed raising rates won’t affect you. While locking in a new loan at a higher interest rate likely does mean you’ll pay more in the long run, it may not be enough of a difference that you should rethink your purchasing decisions, says Karen Gajeski, Thrivent Federal Credit Union’s senior vice president of mortgage banking and consumer business development.

“Nobody can predict exactly what’s going to happen,” she says. “With the rising mortgage interest rates, we are starting to see signs that the housing market is slowing down. This could start to moderate or decrease housing prices. It really isn’t all about interest rates. It’s about what you can afford, and then finding the house that fits into that picture.”

What might be ahead for Fed policy around interest rates?

There are signs that the economy is starting to slow. “However, I do think we’ll continue to see the Fed raise rates,” says Lowe. “Because inflation has gotten so high, the Fed needs to take a firmer hand when it comes to raising rates.”

The Fed has expressed, in their own words, an unconditional commitment to fighting inflation, Lowe says. The market has priced in more rate hikes in 2022 and 2023, and plans indicate rates may go as high as 4%. “It’s significantly above the estimated neutral interest rate of around 2-2.5%, so this action should soon start to moderate inflation.”