On March 22, 2023, the Federal Reserve announced the increase of interest rates by another 0.25 points. Prior to this news, federal fund rates (interest rates set by the Federal Reserve) were at 4.75%. Now they are at 5%. This means that now private banks cannot lend money to consumers and businesses below this 5%. This increase in interest rates means that the credit market will be much tighter. This suggests that it will be much more difficult for consumers and businesses to obtain a loan from the bank to finance their homes, cars, or expand their business operations.
The United States is a country that operates on credit. People use credit to purchase a house, a car, to pay for a wedding, to start a business, to expand their business operations, and so and so forth. Credit is an essential part of the American economy. Increasing interest rates will make access to credit very difficult. From 2008 until 2022, the Federal Reserve printed a lot of money, which increased the level of liquidity in the economy and the velocity of money. Inflation reached the galloping stage following the pandemic. At this stage, inflation generally increased from 3% to nearly 10%, and this is exactly what happened between the pandemic and today.
When COVID-19 happened, the economy shut down. To resume economic activity, the Feds sharply increased the money supply without a proportional increase in the supply of goods and services. This was one of the worst and most nonsensical decisions that the Federal Reserve ever made. This decision to increase liquidity recklessly led to a demand-pull type of inflation. Thus, the need for goods and services was much higher than the available capacity required to meet it. Everyone was home, feeling richer and, therefore, spending more carelessly artificial money because the Feds irresponsibly increased the money supply and lowered interest rates to nearly zero, while supply could not follow up due to a halt in the supply chain. This resulted in what we know today: a drastic increase in the prices of goods and services. Since 2022, the Federal Reserve has been increasing interest rates consistently as a way to clean up the mess they, themselves, created. The credit market is essentially driven by interest rates. Increasing rates means tightening access to credit. It becomes more expensive to borrow. What happens to the economy when the credit market is tightened?
Sources: U.S. Bureau of Labor Statistics
Economic growth slows, and unemployment may rise. When it becomes costly for businesses to borrow in order to expand their operations, they start cutting costs, and the main way to cut their cost is to “do more with less,” meaning laying off since employees are considered an operating expense to the business. Laying off people creates unemployment. And when unemployment occurs, spending drops because people have no income, and businesses generate less revenues which lead to laying off more people. Thus the cycle continues. Jerome Powell predicted that unemployment would rise to 4.5% by the end of 2023.
Sources: Case-Shiller Home Price Index
For consumers, tightening the credit market means that it becomes much more expensive for them to buy a house or a car, or even paying their credit card debt. For prospective homeowners, a tight credit market might be a blessing in disguise. Since a tight credit market makes the cost of borrowing more expensive, it will then decrease demand for housing, which means that housing prices will fall. In the short-term, a tight credit market makes mortgage rates very expensive. Now, less people will be inclined to buy a house at such high-interest rates. A tight credit market will incentivize consumers to save for the future, and for prospective homeowners, a tight credit market will give them time to adjust and maybe increase their income in order to be eligible as homeowners, if they are employed. Because when interest rates increase, the minimum income requirement to qualify as a homebuyer also increases. If people are able to save more while the price of housing is nosediving, then prospective homebuyers will be able to afford homes they couldn’t initially afford.