Fed Interest Rate Hike: What the 0.75 Percentage Point Increase Actually Means

This story is part of Recession Help Desk, CNET’s coverage of how to make smart money moves in an uncertain economy.

The Fed recently raised interest rates again in an attempt to counteract rising inflation, but prices have yet to stumble.

And this likely isn’t the last rate hike of the year. Jerome Powell, chair of the Federal Reserve, said he anticipates additional rate increases, totaling a minimum of 1 percentage point by year’s end. This next rate hike could happen as early as September, at the Fed’s next meeting. 

“These rate hikes have been large and they’ve come quickly,” Powell said during Wednesday’s press conference. “It’s likely that their full effect has not been felt by the economy. So, there’s probably significant additional tightening in the pipeline. While another unusually large increase could be appropriate for our next meeting, that is a decision that will depend on the data we get. We will continue to make decisions meeting by meeting and communicate our thinking as clearly as possible.”

Raising interest rates is the main action the Fed can take to try to counter high inflation. When it costs more to borrow — as with credit cards, mortgages and other loans — consumers have less spending power and will buy fewer items, decreasing the “demand” side of the supply-demand equation, theoretically helping to lower prices. 

But the Fed hasn’t been able to contain inflation yet, and experts worry that further increases to the cost of borrowing money could contract the economy too much, sending us into a recession: a shrinking, rather than growing, economy. The Fed acknowledges the adverse effects of this restrictive monetary policy.

“We are highly attentive to inflation risks and determined to take the measures necessary to return inflation to our 2% longer run goal,” Powell said. “This process is likely to involve a period of below-trend economic growth, and some softening in labor market conditions. But such outcomes are likely necessary to restore price stability and to set the stage for maximum employment and stable prices over the longer run.”

As rates rise and inflation continues to swell, you may be wondering how we got here. We’ll break down everything you need to know about what’s causing record high inflation and how the Fed hopes to bring levels back down.

What’s going on with inflation?

In June, inflation surged to 9.1% over the previous year, reaching its highest level since November 1981, according to the Bureau of Labor Statistics. Gas prices rose by 11.2% in June, bringing the increase in energy to 41.6% over the past 12 months. Food prices also increased by 1% last month, bringing that 12-month increase to 10.4% overall. 

During periods of high inflation, your dollar has less purchasing power, making everything you buy more expensive, even though you’re likely not getting paid more. In fact, more Americans are living paycheck to paycheck, and wages aren’t keeping up with inflation rates. 

Why is inflation so high right now?

In short, a lot of this can be attributed to the pandemic. In March 2020, the onset of COVID-19 caused the US economy to shut down. Millions of employees were laid off, many businesses had to close their doors and the global supply chain was abruptly put on pause. This caused the flow of goods produced and manufactured abroad and shipped to the US to cease for at least two weeks, and in many cases, for months, according to Pete Earle, an economist at the American Institute for Economic Research.

But the reduction in supply was met with increased demand as Americans started purchasing durable goods to replace the services they used prior to the pandemic, said Josh Bivens, director of research at the Economic Policy Institute. “The pandemic put distortions on both the demand and supply side of the US economy,” Bivens said. 

Though the immediate impacts of COVID-19 on the US economy are easing, labor disruptions and supply-and-demand imbalances persist, including shortages in microchips, steel, equipment and other goods, causing ongoing slowdowns in manufacturing and construction. Unanticipated shocks to the global economy have made things worse — particularly subsequent COVID-19 variants, lockdowns in China (which restrict the availability of goods in the US) and the war in Ukraine (which is affecting gas and food prices), according to the World Bank.

Powell confirmed the World Bank’s findings at the Fed’s June meeting, calling these external factors challenging because they are outside of the central bank’s control. 

Some lawmakers have also accused corporations of seizing on inflation as an excuse to increase prices more than necessary, a form of price gouging.

Why is the Federal Reserve raising rates?

With inflation hitting record highs, the Fed is under a great deal of pressure from policymakers and consumers to get the situation under control. One of the Fed’s primary objectives is to promote price stability and maintain inflation at a rate of 2%. 

By raising interest rates, the Fed aims to slow down the economy by making borrowing more expensive. In turn, consumers, investors and businesses pause on making investments and purchases with credit, which leads to reduced economic demand, theoretically reeling in prices and balancing the scales of supply and demand. 

The Fed raised the federal funds rate by a quarter of a percentage point in March, followed by a half of a percentage point in May and three-quarters of a percentage point in mid-June. In July, the Fed raised rates by another three-quarters of a percentage point. 

The federal funds rate is the interest rate that banks charge each other for borrowing and lending. And there’s a trickle-down effect: When it costs banks more to borrow from one another, they offset it by raising rates on their consumer loan products. That’s how the Fed effectively drives up interest rates in the US economy. 

The federal funds rate now sits at a range of 2.25% to 2.5%. But the Fed thinks this needs to go up significantly to see progress on inflation, likely into the 3.5% to 4% range, according to Powell. The Fed’s latest estimate is that, by the end of this year, the federal funds rate will sit at a range of 3.25% to 3.50%.

However, hiking interest rates can only reduce inflationary pressures so much, especially when the current factors are largely on the supply side — and are worldwide. A growing number of economists say that the situation is more complicated to get under control, and that the Fed’s monetary policy alone is not enough.

Could rising interest rates spark a recession?

We can’t yet determine how these policy moves will broadly affect prices and wages. But with more rate hikes projected this year, there’s concern that the Fed will overreact by raising rates too aggressively, which could spark a more painful economic downturn or create a recession. 

The National Bureau of Economic Research, which hasn’t yet officially determined if the US is in a recession, defines a recession as “a significant decline in economic activity that is spread across the economy and lasts more than a few months.” That means a declining gross domestic product, or GDP, alongside diminishing production and retail sales, as well as shrinking incomes and lower employment. 

Pushing up rates too quickly might reduce consumer demand too much and unduly stifle economic growth, leading businesses to lay off workers or stop hiring. That would drive up unemployment, leading to another problem for the Fed, as it’s also tasked with maintaining maximum employment. 

In a general sense, inflation and unemployment have an inverse relationship. When more people are working, they have the means to spend, leading to an increase in demand and elevated prices. However, when inflation is low, joblessness tends to be higher. But with prices remaining sky-high, many investors are increasingly worried about a coming period of stagflation — the toxic combination of slow economic growth with high unemployment and inflation. 

Here’s what higher interest rates mean for you

For the past two years, interest rates had been at historic lows, partially because the Fed slashed rates in 2020 to keep the US economy afloat in the face of lockdowns. The Fed kept interest rates near zero, a move made only once before, during the financial crisis of 2008. 

For the average consumer, increased interest rates means buying a car or a home will get more expensive, since you’ll pay more in interest. Higher rates could make it more expensive to refinance your mortgage or student loans. Moreover, the Fed hikes will drive up interest rates on credit cards, meaning that your debt on outstanding balances will go up. 

Securities and crypto markets could also be negatively impacted by the Fed’s decisions to raise rates. When interest rates go up, money is more expensive to borrow, leading to less liquidity in both the crypto and stock markets. Investor psychology can also cause markets to slide, as cautious investors may move their money out of stocks or crypto into more conservative investments, such as government bonds.

On the flip side, rising interest rates could mean a slightly better return on your savings accounts. Interest rates on savings deposits are directly affected by the federal funds rate. Several banks have already increased annual percentage yields, or APYs, on their savings accounts and certificates of deposit in the wake of the Fed’s rate hikes.

We’ll keep you updated on the evolving economic situation as it develops.