Everyday Economics: The Fed is betting the economy can absorb higher rates

(The Center Square) – The Federal Reserve raised interest rates last week for the first time since 2023, lifting its target range by a quarter point to 3.75%–4.00%. The vote was unanimous.

Before the meeting, I had two questions. We now have answers.

First, would the Fed continue treating inflation as a supply-shock story? In July, policymakers blamed some of the increase on energy supply shocks – the kind of price pressure central banks generally try to look through. That language disappeared from the new statement. In its place: “inflation remains elevated” and a commitment to achieve a “timelier return” to 2%.

The Fed has stopped looking through the shock.

Second, was this a one-time hike or the beginning of something more? The Fed’s projections point to more. The median policymaker now expects the federal funds rate to end 2026 at 4.1%, up from 3.8% in June. That effectively pencils in another quarter-point increase this year, followed by no reduction through 2027.

For households and businesses, the message is straightforward: relief from high borrowing costs is not coming soon.

Higher rates make credit more expensive and tighten financial conditions. Businesses become more reluctant to finance equipment, expand operations or hire workers. Wage growth and consumer spending slow. Households pay more on credit cards, auto loans and other variable-rate debt.

There are winners. Savers earn more on money-market funds, certificates of deposit and high-yield savings accounts. Retirees and other households with substantial cash holdings receive more interest income without taking additional risk.

But higher rates primarily reward households that already have money to save at the expense of those who need to borrow. The burden falls especially hard on lower-income households and younger borrowers, who are already squeezed by high living costs and have fewer financial assets earning those higher returns.

Credit-card delinquency rates are highest among younger borrowers, while a low-hiring labor market makes it harder for them to find a job, increase their income or recover from a financial setback. First-time homebuyers, small businesses and property investors that depend on refinancing also lose. Existing homeowners with fixed-rate mortgages are largely insulated –as long as they do not need to move.

That is how monetary policy reduces inflation: by weakening demand. The Fed is trying to slow economic activity enough to keep the recent inflation shock from spreading.

The latest data help explain why policymakers believe the economy can absorb that risk.

Retail sales strengthened in August, with gains spread across nearly the entire report. But the headline bounce overstated the improvement. August followed a July decline, and averaging the two months reveals moderate – not booming – spending growth. Durable-goods purchases remain strong, while inflation-adjusted nondurable spending is slightly lower than a year ago.

The consumer remains resilient, but the caveats matter. The headline numbers describe the average household, and the average is increasingly misleading. Higher-income households, supported by rising financial wealth, continue to spend. Many lower-income and younger households are struggling with weak real income growth, low savings and rising credit-card delinquencies. Higher borrowing costs will deepen that divide.

Housing shows the same split. Affordability is stretched, existing-home sales remain weak and much of the market is under pressure. Yet housing has proved more resilient than the interest-rate headwinds might suggest largely because the luxury market is holding up.

Over the three months ending in July, the estimated luxury buyer pool increased 3.6% from a year earlier while active luxury inventory fell 2.2%. That pushed luxury prices up 5.3% year-over year – more than twice the pace in the middle of the market. By August, the broader market was moving in the opposite direction: its buyer pool was down 2%, while active inventory was up 2.7%.

Wealthier buyers have benefited more from rising stock values and are less dependent on mortgage financing. For everyone else, high rates, slowing wages and a frozen labor market continue to restrict mobility. Housing looks resilient in the aggregate, but that resilience is being driven disproportionately by the wealthiest households.

Data showing resilient spending alongside lingering inflation risks help explain why the Fed raised rates. The wager is that the economy can withstand tighter financial conditions.

But averages can conceal who absorbs the pain. Lower-income households, younger borrowers and businesses are the ones being asked to prove it.