What Happens When the Fed Raises Rates?

When the Federal Reserve raises the federal funds rate, it increases the cost of borrowing throughout the economy. Higher rates make mortgages more expensive, increase corporate debt service costs, raise the bar for business investment returns, and make holding cash and short-term bonds more attractive relative to risk assets. The Fed typically raises rates to combat inflation or to normalize policy after an extended period of accommodation.

Rate hikes work with a lag — the conventional wisdom is 12 to 18 months for the full effect to filter through the economy. This means the damage from tightening often does not become apparent until well after the hiking cycle is underway. Markets, however, try to price in the effects in advance. The initial hikes are often tolerated by equities if the economy is strong, but as the cumulative tightening builds, cracks begin to appear in rate-sensitive sectors first: housing, autos, and levered corporate borrowers.

The most dangerous phase is often the end of a hiking cycle, when the cumulative effect of higher rates collides with an economy that may have already slowed. The Fed frequently overtightens because the data it relies on is backward-looking. By the time lagging indicators like unemployment begin to deteriorate, the restrictive policy may have already pushed the economy toward contraction.