Most of the Federal Reserve’s interest rate hikes may be in the rearview mirror, but U.S. central bankers aren’t yet done making it more expensive to borrow money.
After spending all of last year raising interest rates at a speed unmatched since the 1980s, Fed policymakers are taking a different approach in 2023: Hiking interest rates at a slower and more deliberate pace. U.S. central bankers in February lifted interest rates by a quarter of a percentage point, the smallest rate hike since last March.
But the Fed’s more leisurely path doesn’t signal anything about its final destination. Interest rates are now at the highest since 2007, and the Fed still has more rate hikes up its sleeves. Policymakers could raise rates to 5-5.25 percent before it’s all said and done, signaling two more quarter-point moves from here, according to the median forecast among Fed officials from December.
Yet, there’s room for error in almost every prediction. Seven Fed officials saw a scenario where rates could rise even higher than that, with the most aggressive forecasts penciling in a 5.5-5.75 percent target range, the highest since 2000. Bankrate’s Greg McBride, CFA, meanwhile, settled on a 5.25-5.5 percent for the year in his 2023 rate forecast.
Even if the Fed’s highest forecasts come to fruition, it shows that, at most, only 1 percentage point of rate hikes are on the table for the year, nowhere near as steep as the 4.25 percentage points of tightening Fed officials approved in 2022.
Still, more rate hikes equal higher borrowing costs, which are unlikely to fall until the Fed starts to cut interest rates — a policy path no official has said they’re expecting to approve this year.
For consumers, the key prices they pay on mortgages or credit cards might not rise as much as in 2022, but they’ll still be among the highest levels many borrowers have seen for decades. That’s on top of growing recession odds, as higher interest rates risk slamming the brakes on the economy and job market. Economists in a Bankrate poll put the odds of a recession for 2023 at 64 percent.
“Not only is it a concern, but the odds favor it,” McBride says. “Look at the last three [tightening] cycles: Two of them ended in recessions, and the one that didn’t was an economic slowdown, where they had to reverse course and start cutting rates. History is not on their side.”
Fed’s rate moves depend on inflation and employment data
Where the Fed is heading — and where it’ll end up — depends on inflation and the labor market.
The Fed’s rapid rate hikes look like they’re starting to do their job, with inflation in December cooling to 6.5 percent from its 9.1 percent peak in June. Improvement, however, hasn’t been felt across the board, and economists are divided on how much more quickly price increases will slow. Electronics, gasoline and used vehicles are the only items cheaper than they were a year ago. Food prices are still climbing almost two times faster than overall inflation, while rent saw the biggest burst of speed on record.
The labor market also still remains red-hot. Employers added 4.8 million jobs in 2022, and businesses created another 517,000 new jobs in January, both almost three times faster than the pre-pandemic pace from 2019. Job creation is outstripping population growth, suggesting employers are adding more jobs than is sustainable, experts say. There are about 1.9 job openings per every unemployed individual, Labor Department data shows, reflecting too few workers for too many vacant positions.
Fed Chair Jerome Powell said the can’t-be-tamed labor market might be one of the key causes of inflation — and it could make inflation more stubborn, prompting the Fed to take rates even higher. Such is especially the case for services, where costs could keep rising depending on how much it costs to recruit and retain talent.
Companies desperate for workers often lift wages, but if they can’t find a way to eat those higher labor costs, they end up making the consumer bear the burden by increasing prices. Those higher costs are then reflected in the Department of Labor’s measure of services inflation, which is up 6.8 percent from last year, the sharpest jump since August 1982.
One such example: The price of dining out at a restaurant has jumped 8.2 percent over the past 12 months — likely related to how average hourly earnings for workers in leisure and hospitality are up 7 percent, Labor Department data shows.
“You’re not going to have a sustainable return to 2 percent inflation in that sector without a better balance in the labor market,” Powell said at the Fed’s February post-meeting press conference. “But I still think there’s a path to getting inflation back down to 2 percent without a really significant economic decline or a significant increase in unemployment.”
Just 39 percent of workers in a Bankrate September poll reported not receiving a better-paying job nor a pay raise, down from 56 percent in 2021, 50 percent in 2019 and 62 percent in 2018.
But the survey also suggested a vicious inflationary cycle could be afoot. Half of the workers who received a raise or a better-paying job say the increase didn’t keep up with inflation, Bankrate’s poll also found. That could prompt even more workers to start asking for even higher pay.
Every Fed official said the odds favor higher inflation than lower inflation, meaning prices could rise even higher than the 3.1 percent rate they’re expecting for next year, their economic projections show.
“They may or may not be right with that risk assessment, but it tells you a lot about where they’re willing to air,” says Kathy Bostjancic, chief economist at Nationwide. “It feeds into their hawkish stance, and they’re willing to air on the side of higher interest rates because of the risk of inflation being higher.”
The Fed’s forecasts show unemployment hitting 4.6 percent in 2023, 0.9 percentage point higher than its current 3.7 percent level. That’s by far not the worst labor market jobseekers have ever seen (unemployment hit 14.7 percent during the coronavirus pandemic and 10 percent in the aftermath of the Great Recession), but it would no longer be a historic low.
There’s a possibility unemployment might not have to rise that much to cool inflation. Prices are slowing at a time when joblessness is still plummeting, and wage growth is moderating.
Interest rates, however, often take a while to filter through the economy, and the job market is one of the last places they end up affecting. Experts say it may take a year for the full effect of a rate hike to be realized in slower job growth and fewer job openings. A year ago, rates were still at near-zero percent.
With rates no longer stimulating economic growth, each rate hike from here could have an even greater effect on the U.S. economy.
“If you’re balancing risks and you get less worried about the economy slowing and more worried about inflation just staying high and getting built in to the price and wage-setting process, then you might conclude you need to move faster,” says Bill English, a finance professor at the Yale School of Management, who spent 20 years at the Fed. “Lags just make the problem harder because you have to be forward-looking and judge where the economy is going to be.”
Markets fear that defeating inflation means starting a recession
Fears of a recession are far and wide right now. One such example: The 10-year Treasury yield has been trading below the 2-year rate since early July. This inverted yield curve has long been used as a Wall Street recession indicator.
When the yield curve inverts, it shows that investors are expecting a downturn — and it also makes the flow of credit more restrictive when long-term borrowing is cheaper than short-term rates.
Markets also took a beating in 2022, posting their worst performance since 2008, as investors wrestled with those building recession risks. The largest cluster of experts in Bankrate’s Market Mavens survey said the next bull market won’t begin until the second half of 2023.
Part of the anxiety about inflation all along has been that a downturn is its only cure, likely informed by markets’ bad experiences during the stagflationary-era of the 1970s and early 1980s.
Back then, the Fed manufactured what was, at the time, the worst recession since the Great Depression, hiking its benchmark borrowing rate all the way to a 15-20 percent target range. The idea that expansions don’t just die of old age has long been the lore on Wall Street.
Even more market volatility could be in store for 2023, especially considering investors and Fed officials aren’t aligned on how much higher interest rates will rise. Investors think rates will peak at 5-5.25 percent and see the Fed cutting rates as soon as they fall, according to CME Group’s FedWatch. Fed officials don’t share those forecasts.
What to do with your money when rates are expected to rise and recession risks are high
The highest rates in more than a decade also mean an end to cheap money. Take steps now to prepare your finances for a new era of monetary policy, one that will mean more expensive borrowing costs down the road.
- Keep a long-term mindset: Plunging stocks mean pain for investors, and the possibility of a recession or even higher Fed interest rates could worsen the volatility. But don’t succumb to market volatility and change up your approach. Remember, a diversified portfolio and a long-term mindset protect you through the most brutal times in the stock market.
- Pay down debt: Consumers with fixed-rate debt won’t feel any impact from a Fed rate hike, but you are more fragile if you have a variable-rate loan, especially if it’s a high-interest credit card. The average credit card rate keeps breaking records, hitting 19.95 percent as of Feb. 1, according to Bankrate data. Consider consolidating that debt with a balance-transfer card to help you make a bigger dent in your principal balance. Homeowners with an adjustable-rate mortgage or a home equity line of credit (HELOC) might want to consider refinancing into a fixed-rate loan. “You don’t want to be a sitting duck for higher interest rates on your credit card or home equity line of credit,” McBride says.
- Boost your emergency savings: High inflation shouldn’t keep consumers from building up a cushion of cash in case of emergency expenses. In fact, rising recession risks only underscore the urgency.
- Find the best place for your cash: Savers can earn even more money on their cash by switching to a high-yield savings account. Many accounts on the market are offering consumers who bank with them yields above 4 percent. If you put an initial $10,000 deposit into an account with a 4 percent annual percentage yield (APY), you’d earn $400 in interest, compared with just $23 on the average savings yield of 0.23 percent.
- Think about recession-proofing your finances: Given that plenty of risks lie ahead for the Fed, always be on the lookout for ways that you can recession-proof your finances. Along with building up your emergency fund, experts say it comes down to living within your means, staying connected with your network, identifying your risk tolerance and staying focused on the long haul if you’re an investor.
“A recession in 2023 is not a sure thing, but there’s broad agreement that the risks of one remain,” says Mark Hamrick, Bankrate senior economic analyst. “To relieve individuals, households and businesses of historically high inflation, the Fed has been prepared to accept the risk of a recession if it achieves the mandate of stable prices. Choosing from the least of two evils, it isn’t dissimilar from when firefighters trade some damage from water for fire damage.”
