The Ripple Effects of Rising Interest Rates on Banks and the Economy
Sharply Climbing Rates Hit Banks, Here’s What Else Is At Risk
The Federal Reserve’s recent decision to increase interest rates at a historically high pace to control inflation has contributed to the collapse of several banks. While the move was necessary to curb inflation, its side effects are far-reaching. They could impact the housing market, lead to a recession, and even affect the federal budget if sustained over the coming months and years.
Over the past year, the Federal Funds rate has gone from virtually zero to over 4.5%. Such a sudden change in interest rates puts pressure on banks as their assets, typically government debt and other fixed-income assets, decrease sharply in value as rates rise. This has contributed to the collapse of Silicon Valley Bank, Signature Bank, and First Republic Bank. It has also created pressures internationally, such as at Credit Suisse. As a result, markets believe that we may be reaching the top of the interest rate cycle. However, this sharp change in yields still poses a significant threat to the financial system, and there may be more to come beyond the banking sector.
Declining Home Prices
Rising interest rates work through home prices, meaning annual declines may be on the horizon. The rise in mortgage rates, doubling off recent lows from 3% to 6%, has led to a major decline in housing affordability. Since many households’ largest assets are their homes, declining home values could broadly impact consumers. While home prices had fallen from peak levels last summer, we have yet to see year-on-year declines in most home price measurements. Nonetheless, such a decline could be forthcoming over the next few months. The possible disruption in the home building could elevate recession risk. Additionally, the commercial real estate sector is under threat, particularly because office occupancy remains low as remote work remains a fixture of various white-collar industries.
The Federal Reserve’s recent banking crisis does not mean we have reached a recession. The US economy has defied expectations over recent months, with job growth, in particular, remaining robust as service industry growth more than offsets layoffs in certain sectors such as tech. However, the Fed has hinted that it may take a recession to control inflation in the US fully. Moreover, the yield curve, historically an accurate predictor of recession, also strongly signals that a recession could be imminent.
The Federal Budget
Interest rates at high levels will start eating into the federal budget. Due to the pandemic response and other initiatives, the US government has taken on increasing debt over recent years. However, the increase in interest rates could lead to a budget deficit. The Congressional Budget Office (CBO) reports that rising interest rates would cause the federal budget deficit to grow, and the recent banking crisis has only added to this concern.
- The Federal Reserve has increased interest rates, aiming to control inflation, contributing to the collapse of some banks.
- Rising interest rates could cause home prices to decline, leading to a major fall in housing affordability.
- Given the strong recession signals in the yield curve, a recession seems imminent.
- The federal budget could be affected, leading to a possible budget deficit due to increased interest rates, which may exceed the amount it can afford.
The rise in interest rates may curb inflation. Still, it comes with several potential problems, including but not limited to: banking failures, falling home prices, increased recession risk, and budget deficits.
The Federal Reserve’s recent interest rate hike points to inflation concerns, but the potential impact is more far-reaching than many people realize. Its side effects have contributed to banking failures, threatening the housing market, and could lead to a recession, to name a few. Policymakers should consider various steps to address these concerns cautiously. Ultimately, it is better to be proactive than reactive and prevent such financial problems from emerging in the first place.