Glenn Hegar
Texas Comptroller of Public Accounts
Glenn Hegar
Texas Comptroller of Public Accounts
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Glenn Hegar
Texas Comptroller of Public Accounts
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economy


FiscalNotes

A Review of the Texas Economy

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Impacts of Higher Interest Rates on Texas Federal Reserve Hikes Rates to Combat Inflation

By Landre Buzard Published October 2023

Interest rates play a fundamental role in our financial systems and in our lives. At its core, an interest rate is the cost of borrowing money or the return earned on fixed income investments. It represents the percentage charged or earned on a loan, mortgage, credit card balance or savings account.

In the U.S., the Federal Reserve Board sets the federal funds rate, which determines the cost at which depository institutions, such as banks and credit unions, lend reserve balances to each other overnight on the federal funds market. This rate is essentially the interest rate at which banks borrow and lend money among themselves. Its impact cascades through the financial landscape, molding the rates on various financial products, including personal savings accounts, credit cards and mortgages.

As of July 2023, the effective federal funds rate (calculated as a volume-weighted median of overnight federal funds transactions) stood at 5.33 percent — the highest rate since before the financial crisis of 2007-2009 and up from 0.08 percent in early 2022. The steady rise in interest rates was in direct response to rapidly rising inflation rates, which reached 6.6 percent in September 2022, the highest rate in 40 years (Exhibit 1).

Exhibit 1: EFFECTIVE FEDERAL FUNDS RATE AND CORE INFLATION RATES, 1960-2023

Note: Inflation rate is year-over-year change in the Consumer Price Index.
Sources: U.S. Bureau of Labor Statistics; Board of Governors of the Federal Reserve System; Federal Reserve Bank of St. Louis


Current Landscape

Central banks such as the Federal Reserve (the Fed) raise interest rates to combat inflation. Mike Reissig, chief executive officer of the Texas Treasury Safekeeping Trust Company, says, “You can’t discuss interest rates without first discussing and understanding inflation. The very existence of interest rates is an adjustable compensation for inflation for lenders, such that rates rise or decline either in response to past or current fluctuations in inflation, or in anticipation of changes in inflation.”

Before 2020, there was a long period of low inflation. However, the arrival of the COVID-19 pandemic in early 2020 caused various market problems, including vast disruptions to global supply chains and the effect of large cash infusions from the government to help avoid recession. Throughout 2021 and 2022, the labor market experienced tightening, resulting in a rise in core inflation — the price of goods and services, excluding volatile food and energy prices. This was influenced by the growing ratio of job vacancies to unemployment, and the inflationary pressure was further exacerbated by the war in Ukraine.

According to the Federal Open Market Committee (FOMC) meeting in July, “The Committee seeks to achieve maximum employment and inflation at the rate of 2 percent over the longer run. In support of these goals, the Committee decided to raise the target range for the federal funds rate to 5 14 to 5 12 percent (Exhibit 2).”

Exhibit 2: Federal Fund Rate Hikes

FOMC Meeting Date Rate Change (Base Points) Federal Funds Rate Target Range
July 27, 2023 +25 5.25% to 5.50%
May 4, 2023 +25 5.00% to 5.25%
March 23, 2023 +25 4.75% to 5.00%
Feb. 2, 2023 +25 4.50% to 4.75%
Dec. 15, 2022 +50 4.25% to 4.50%
Nov. 3, 2022 +75 3.75% to 4.00%
Sept. 22, 2022 +75 3.00% to 3.25%
July 28, 2022 +75 2.25% to 2.50%
June 16, 2022 +75 1.50% to 1.75%
May 5, 2022 +50 0.75% to 1.00%
March 17, 2022 +25 0.25% to 0.50%

Source: Board of Governors of the Federal Reserve System


Why the Fed Raises Rates

When inflation rises too rapidly, it can disrupt economic stability and negatively impact households and businesses. To mitigate this disruption, the Fed raises interest rates to make borrowing more expensive for individuals and businesses. This can discourage borrowing and reduce spending, which typically helps cool demand for goods and services in the economy.

When interest rates increase, it becomes more expensive for banks to borrow money from the Fed. This leads to a reduction in the money supply as banks have fewer funds available for lending. With less money circulating in the economy, the potential for inflationary pressures diminishes. Moreover, by demonstrating its commitment to combat inflation through the tightening of monetary policy, the Fed can shape the expectations of businesses and consumers. If the Fed anticipates lower inflation, it can help anchor price expectations and moderate wage and price increases. Exhibit 3 shows a history of the Fed’s efforts to tackle inflation and shape inflation expectations.

Exhibit 3: History of Federal Reserve Monetary Policy Actions

Year Event/Policy Action
1914 In the early years of the Federal Reserve System, the 12 Reserve Banks are relatively autonomous and set their own policies and discount rates with approval from the Federal Reserve Board.
1923 The Board establishes the Open Market Investment Committee to centralize open market operations under the general supervision of the Board and away from individual Reserve Banks. It also is intended to better coordinate Federal Reserve and Treasury policies.
1935 The Banking Act of 1935 creates the modern structure of the Federal Open Market Committee (FOMC), including the rotation of Reserve Bank presidents. Control of open market operations is officially vested in the FOMC. These operations are implemented through the trading facilities at the Federal Reserve Bank of New York.
1951 The Treasury and the Fed declare they have “reached full accord with respect to debt management and monetary policies to be pursued in furthering their common purpose and to assure the successful financing of the government's requirements and, at the same time, to minimize monetization of the public debt.” The new accord allows the Fed to begin pursuing an independent monetary policy.
1961 In an attempt to both lessen the balance-of-payments deficit and end the recession, the Fed purchases long-term Treasury bonds while simultaneously selling short-term bills. The move is intended to flatten or “twist” the normal upward-sloping yield curve.
1977 The new Federal Reserve Reform Act explicitly directs the Fed to “promote the goals of maximum employment, stable prices, and moderate long-term interest rates” and requires the Board of Governors to report at semiannual hearings before both the House and Senate about the FOMC's objectives, performance and plans for the growth of money and credit.
1980 Among other changes to the banking industry, the Depository Institutions Deregulation and Monetary Control Act of 1980 requires all depository institutions to meet reserve requirements. This change strengthens the Fed's ability to control the money supply.
2001 In response to the Sept. 11 terrorist attacks, the Board of Governors issues a simple statement that “The Federal Reserve System is open and operating. The discount window is available to meet liquidity needs.” The FOMC follows up by lowering the federal funds rate target by 50 basis points, to 3 percent.
2008 The Federal Reserve Board announces it will pay interest on depository institutions' required and excess reserve balances. Paying interest on reserves later develops into the Fed's primary tool for steering the federal funds rate into the target range set by the FOMC.
2010 The Dodd-Frank Wall Street Reform and Consumer Protection Act provides wide-ranging prescriptions aimed at correcting the causes of the 2007-2009 financial crisis. The Fed lost some autonomy to extend emergency credit to non-bank institutions.
2014 The Policy Normalization Principles and Plans states the FOMC intends to use an overnight reverse repurchase agreement facility as a supplementary policy tool to help control the federal funds rate.
2019 The FOMC formalizes its use of several new tools to “implement monetary policy in a regime in which an ample supply of reserves ensures that control over the level of the federal funds rate and other short-term interest rates is exercised primarily through the setting of the Federal Reserve's administered rates” and notes “the supply of reserves is not required.”
2020 To support the economy and financial markets during the COVID-19 pandemic, the FOMC takes decisive action, providing support in three ways: (1) To reduce borrowing costs for households and businesses, the FOMC lowers the federal funds rate to 0-25 basis points; (2) the Fed buys U.S. Treasury securities and mortgage-backed securities to stabilize financial markets; (3) the Fed uses the authority of the Federal Reserve Act to support the flow of credit to businesses, households and communities by introducing several temporary lending and funding facilities.
2023 Regulators shut down Silicon Valley Bank and Signature Bank — the largest bank failures since 2008 and the third- and fourth-largest on record. In response, the Federal Reserve Board announced it would make available additional funding to eligible depository institutions to help ensure banks can meet the needs of all their depositors. The additional funding was made available through the creation of a new Bank Term Funding Program, offering loans of up to one year in length to banks, savings associations, credit unions and other eligible depository institutions.

Source: Federal Reserve Bank of St. Louis


How the Fed Raises Rates

The Fed’s tools for raising interest rates have evolved over time. In the past, it primarily used the federal funds rate and open market operations to influence the supply of money and credit. It operated under a “limited reserves” framework, in which a target was set for the federal funds rate and the supply of reserves was adjusted by buying or selling U.S. government securities. However, the financial crisis of 2007-2009 prompted changes, leading the FOMC to lower its target for the federal funds rate to near zero and increasing the level of reserves from around $45 billion to more than $2.7 trillion. This was achieved gradually, with the biggest increase occurring between 2008 and 2009 (Exhibit 4).

Exhibit 4: LEVEL OF FEDERAL RESERVES, 2007-2014 (ANNUAL)

Source: Federal Reserve Bank of St. Louis


As a result, the Fed adopted the “ample reserves” framework, which it still uses today. It now keeps ample reserves in the banking system and relies on new tools to guide the federal funds rate. The key tools are interest on reserves (IOR) and the overnight reverse repurchase agreement (ON RRP) rate. The IOR occurs when the Fed pays banks interest on the reserves they hold at the central bank. By adjusting the interest rate paid on these reserves, it can influence how much banks choose to lend or keep in reserves.

If the Fed raises the IOR rate, it encourages banks to keep more reserves, reducing the money available for lending and potentially raising interest rates. Not all financial institutions have access to IOR, however, which means there is potential for the federal funds rate to drop below the IOR rate. This is why the Fed uses the ON RRP facilities to control the federal funds rate with smaller banks; it offers these banks an opportunity to lend their excess funds to the Fed overnight and earn a set interest rate. In this way, the Fed ensures smaller banks have an attractive option to borrow from, rather than accept lower rates offered by bigger banks. This helps control the federal fund rate by establishing a minimum interest rate that banks are willing to accept, even with smaller banks involved.

Impact on the Economy

The Fed’s attempts to curb inflation through interest rate hikes could have a notable effect on economic growth, potentially leading to a slowdown. Texas, however, often has outperformed the nation, with its low taxes and business-friendly environment.

A June survey by the Federal Reserve Bank of Dallas (Dallas Fed) found approximately 37 percent of participating firms did not plan to change their capital expenditure plans despite higher interest rates, while 38 percent planned to increase their expenditures. Only 25 percent of the participants said they planned to lower their capital investments in 2023. According to Reissig, a multitude of factors influence capital outlays, such as, “how well managed the firm is, what their balance sheet looks like, what kind of upcoming projects they have, how important those projects are for their continued success and how much can they afford to delay projects right now.”

Texas added 402,000 nonfarm jobs from August 2022 to August 2023, an increase of 3 percent. Its rate of job growth was the highest of the 10 most populous states; it was the second highest of all states, behind only Nevada, according to the Certification Revenue Estimate (CRE), released Oct. 5 by the Comptroller’s office. The CRE projected employment growth of 1.5 percent in fiscal 2024 and 0.3 percent in 2025.

Impact on Consumers

The impact of rising interest rates on Texas consumers can be complex and varied, affecting individuals differently based on their financial habits and economic circumstances. As interest rates climb, the consequences ripple through various aspects of personal finance, reshaping spending patterns and influencing purchasing decisions. For Texas consumers who pay cash for their purchases, rising interest rates might not directly affect their spending habits. These individuals typically have the means to make purchases without relying on credit, which shields them from the burden of interest payments.

As a result, they are less likely to curb their spending in response to higher interest rates and may continue supporting certain sectors of the economy. That being said, if the interest rate paid on an interest-bearing asset is appealing enough, current consumption of durable goods would be delayed. Reissig says, “Rising rates don’t usually affect those who can pay cash but will likely slow spending of those who use credit.” With increasing interest rates, the cost of borrowing rises, making credit-based purchases more expensive. As a result, individuals buying on credit may pull back on their spending to avoid accumulating high-interest debts.

Rising interest rates also affect the housing market. “Mortgage rates are one of the most fundamental ways that higher interest rates affect the economy, because they [interest rates] flow through the mortgage rates, and a home purchase is a huge purchase that has a lot of other economic add-on effects,” says Reissig. As interest rates rise, so do mortgage rates, making homeownership less affordable for some prospective buyers (Exhibit 5).

Exhibit 5: 30-YEAR MORTGAGE RATES, 2021-2023 (MONTHLY)

Source: Federal Reserve Bank of St. Louis


Since 2020, monthly mortgage rates have doubled. If this rapid increase leads to a slowdown in the housing market, it could affect not only real estate agents but also industries associated with home buying, such as furniture and home improvement.

The Implications

Optimism surrounding the Fed’s handling of recent interest rate hikes may not guarantee a soft economic landing in the future. “This is especially true when you consider that rate hikes can have a delayed impact on the economy and inflation markers are still not back in the historic 2 percent range,” Reissig says, pointing out the full consequences of the current monetary policy decisions may not be immediately apparent. “Thus far, the Fed has definitely avoided a bumpy landing,” Reissig says, “but the plane is not on the ground yet.” FN


Keep reading with “Inflation and the Economy” and “Texas’ Rainy Day Fund Projected to Hit Cap for First Time,” or watch our video, “Inflation Basics.”