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The Prolonged Impact of Fed Rate Hikes on Our Economy

Trade & Markets

The U.S. economy, much like a complex puzzle, keeps evolving despite the recent 5.5% benchmark federal funds interest rate set by the Federal Reserve. Understanding why and how this rate hike takes time to affect the economy and its potential to last a decade or more involves peeling back the layers of economic dynamics.

Federal Reserve set the benchmark federal funds interest rate at 5.5% in 2023.

Instagram | Federal Reserve set the benchmark federal funds interest rate at 5.5% in 2023.

The Gradual Ripples of Change

The Federal Reserve’s decisions to increase interest rates don’t create an instant impact on all consumers. The effects are more noticeable among those seeking new loans, such as first-time homebuyers. This delay in impact is due to various factors, including the use of contracts in business that slow down the transmission of these decisions throughout the economy.

“It might not all hit at once, but the longer rates stay elevated, the more you’re going to feel those effects,” explains Sarah House, managing director and senior economist at Wells Fargo.

The Federal Reserve decisions to increase interest rates don't create an instant impact on all consumers

Instagram | The Federal Reserve’s decisions to increase interest rates don’t create an instant impact on all consumers.

Unraveling the Lag Effect

Unlike a swift punch, the consequences of a 1% interest rate increase unfold over time. Research from the Federal Reserve Bank of San Francisco suggests that such an increase can reduce the gross domestic product by 5% for 12 years after the hike. This prolonged impact has implications for both the short and long term.

“It’s bad in the short term because we worry about unemployment, we worry about recessions,” remarks Douglas Holtz-Eakin, president of the American Action Forum. “It’s bad in the long term because that’s where increases in your wages come from; we want to be more productive.”

Markets Responding Swiftly, But Not Instantaneously

Financial markets may react promptly to Federal Reserve policy changes, according to some economists. However, the actual impact might not be instantaneous. Federal Reserve Governor Christopher Waller notes that policy tightening occurs with the announcement, not the immediate execution of the rate change.

Financial markets may react promptly to Federal Reserve policy changes, according to some economists

Instagram | Financial markets may react promptly to Federal Reserve policy changes, according to some economists.

“We’ve seen this cycle where the stock market moved more quickly in some cases, more slowly in other cases,” adds Roger Ferguson, former vice chair of the Federal Reserve. The variability in response time adds a layer of uncertainty to the duration of the economic impact.

The Federal Reserve’s decisions are like the intricate pieces of a puzzle that take time to fall into place. The delayed effects on consumers, the lasting consequences of rate hikes, and the varying speed of market responses all contribute to the complexity of this economic puzzle, shaping the financial landscape for years to come.

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