Fed rate hikes deliver these financial benefits, experts say

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(WASHINGTON) -- The Federal Reserve significantly raised its benchmark interest rate on Wednesday, the latest in a series of hikes meant to tackle sky-high price increases last seen more than four decades ago.

But rate hikes at the Fed risk widespread financial pain. An increase to the benchmark interest rate raises borrowing costs for consumers and businesses, which in theory should slash inflation by slowing the economy and eating away at demand.

That means borrowers will face higher costs for everything from car loans to credit card debt to mortgages. More alarmingly, the approach risks tipping the economy into a recession.

These significant risks, however, come along with potential financial benefits, experts told ABC News. First, the hike in borrowing costs directly benefits savers, who stand to gain from an uptick in the interest yielded by accounts held at banks, they said.

Plus, the effort to bring down inflation holds financial promise, since lower prices would relieve economic hardship and enhance spending power, especially for low- and middle-income households, they added.

"When interest rates rise and money becomes more scarce, people can receive payments for the money they keep on hand at a bank," James Cox, a financial advisor and managing partner of Virginia-based Harris Financial Group, told ABC News.

"Many Americans will like to have interest on their savings for the first time in many years," he added.

The series of rate hikes so far this year has spurred an increase in interest rates for savings accounts at banks, Greg McBride, the chief financial analyst at the research firm Bankrate, told ABC News. The top-yielding savings accounts at the beginning of the year maxed out at 0.55% — now they stand above 2%, he said.

"They're still climbing," he added. "Another big rate hike from the Fed this week — that only sustains the upward momentum."

Online banks and small banks, especially, have raised interest rates on savings accounts as they try to win over customers, McBride said. He contrasted those banks with the larger brick-and-mortar players, which feel less pressure to raise interest rates in this environment because of their strong market position.

"Online banks are among the most competitive out there," he said. "That's where we see banks leapfrogging each other as they continually raise their payouts."

To be sure, the interest rates on savings accounts that hover around 2% still fall far short of the inflation rate, which as of June stood at 9.1%. That means that the increasingly strong returns on savings accounts continue to be heavily devalued by skyrocketing price increases, the experts said.

In theory, however, as interest rates rise, inflation should come down and savings accounts should yield better returns, improving their prospects as a financial option, they added.

"Much of the benefit is illusory at a time when inflation is running north of 9%," McBride said. "But savings accounts are on the rise."

U.S. adults on average hold $62,000 in personal savings, according to a study released by Northwestern Mutual in May. The savings grant many individuals a sizable cushion and potential for taking advantage of rising interest rates on savings accounts.

But high prices have already taken a toll on savings. The average savings have fallen 15% since last year, when they stood at $73,000, Northwestern Mutual found.

In addition to prompting higher yields on savings accounts, Fed rate hikes should eventually deliver lower prices, which will improve the financial outlook of Americans straining under the weight of high costs, the experts said.

In the meantime, rate hikes could cause substantial financial harm, they added. As the central bank slows down the economy and chokes demand, it could bring layoffs that put millions of people out of work and force households to draw down whatever savings they had set aside.

While rate hikes at the Fed address the upward pressure that consumer and business demand places on prices, the hikes do not affect the supply shortages behind some of the cost increases, which owe to COVID disruptions and the Russia-Ukraine war. This dynamic could limit the effect of rate hikes and prolong the downturn.

Highlighting the limitations of rate hikes, Sen. Elizabeth Warren (D-MA) in a Wall Street Journal op-ed on Sunday called them "largely ineffective against many of the underlying causes of this inflationary spike."

But the risk of entrenched inflation outweighs the costs of short-term financial pain, said Cox, the managing partner of Harris Financial Group.

"It's either raise rate hikes very fast to bring down the rate of inflation, or inflation becomes anchored in the economy and all of your personal savings get eaten away by it," he said.

"Unfortunately, it's not without pain," he added. "But it's far less painful to take your medicine upfront than to let the disease take hold."

Wednesday, July 27, 2022 at 4:43PM by Max Zahn, ABC News Permalink