Americans still haven't felt the worst of the war on inflation, meaning 2023 will be 'survival of the fittest'

• The Federal Reserve hiked interest rates seven times during 2022 to fight inflation.
• But it takes time for Americans to actually feel the impact of those rate increases.

When you adjust the faucet in your shower, there's often a lag of several seconds before the water temperature changes and you can feel the effects.

That's the "unfortunate situation" the nation's central bank is finding itself in right now, former Treasury Secretary Larry Summers said in February.

He's referring to the waiting period between the seven interest rate hikes the Federal Reserve has implemented since January 2022 and a marked cooldown in inflation and Americans' spending. While it's been billed as an aggressive strategy, the majority of the pain from the fight against inflation is yet to come.

Fairly quickly, higher rates made borrowing money to buy a car or a house more expensive, but there's also something economists call a "long and variable" lag, which is the period of time between implementation of a monetary policy — like raising interest rates — and results.

It generally takes 12 months or longer for interest rate hikes to have a substantial economic impact, according to economists. That means the new year could bring even more pain to homebuyers, workers, and business owners as borrowing money gets more expensive, layoffs accelerate, and consumer spending slows.

After all, 2022 has been "the tale of two halves," Luke Pardue, an economist at Gusto — a small business payroll and benefits platform — told Insider.

"The overall economy was growing super fast at the beginning of the year," he said. "But as the Fed has begun to cool down the economy, we've seen that reflected in some of the labor market numbers."

But there's a lot of "gray area" in terms of the next steps the Fed will take, Pardue said.

"How much more should they raise rates? Should they take a pause in order to assess the full effects, given that monetary policy operates with a lag?" he continued. "I think that's where, going into 2023, a lot of the question marks are going to lie."

High prices, layoffs depend on the big question for 2023: What will the Fed do next?

When Federal Reserve Chair Jerome Powell announced the most recent interest rate hike in December, 50 basis points, marking a slowdown from the four prior increases of 75 basis points — he noted that Americans will experience "some pain" as a result of his tactics to lower inflation.

However, the Federal Reserve has kept its lips pretty tight on any predictions about whether that pain will come in the form of a recession — and how bad it will be if it does.

"No one knows with any certainty where the economy will be a year or more from now," Powell said.

One thing that seems fairly certain: Americans can anticipate more layoffs in 2023. In December, the Fed predicted that unemployment will climb to 4.6% by the end of next year — an increase from November's level of 3.7%. Predictions could certainly change over the course of the year, but if unemployment moves up by nearly a full percentage point per the Fed's prediction, around 1.5 million Americans could lose their jobs.

On top of that, more consumers will start to avoid big purchases like a car or a house as the economy starts to respond to the impacts of the Fed's interest-rate-hiking, inflation-fighting efforts.

To be sure, the uncertainty makes it difficult to anticipate what exactly Americans will feel from this policy lag. Pardue said that the strong labor market at the end of 2022 is a good sign mass layoffs probably won't happen in the new year.

"A lot of that is also going to mean we're going to see either a slowdown or a very mild recession, just because businesses are incredibly hesitant to let go of the workers that they have been able to attract since the pandemic," he said.

The one thing Powell did say with certainty is that raising interest rates will continue as long as the economy's inflation levels remain well-above what it was pre-pandemic. But if lower inflation levels persist, Powell said, achieving a soft landing — in which the Fed fights inflation while avoiding a recession — is still possible.

"There are a range of outcomes that the Fed could engineer," Pardue said. "It could engineer what we think of as a hard landing, where it raises interest rates by a ton, people pull back their spending, and we enter a downturn. Or it could engineer a softer landing where we come back down to earth in a very controlled way, and I don't think it's going to take much more action from the Fed to see that softer landing, a slower return to Earth."

Still, the Fed projected that inflation will still be above pre-pandemic levels by the end of 2023, and Powell said it'll take "substantially more evidence to give confidence that inflation is on a sustained downward path."

Small business owners anticipate "survival of the fittest" in 2023

The pandemic took a significant toll on the US economy, with inflation at 7.5% year-over-year in January as the country entered its third year battling COVID-19. Americans were feeling a strain on their wallets and prices surged well beyond the 2% level of inflation that existed before the pandemic began.

Kevin Michael Gray, the founder of Arizona-based businesses SignerX.com and WPEsignature.com — document-signing sites that partner with WordPress — told Insider that after the Fed raised interest rates, he noticed a roughly 20% to 30% drop in new purchase revenue. He believes the new year will bring a whole host of different challenges for small businesses.

"I believe that we're going to see small businesses dropping like flies, and competition thinning out among the pandemic entrepreneurs," Gray said. "Inflation is a silent killer for small businesses."

As Americans might start to reign in their spending, businesses will be bringing in less revenue — as as a result, they may have to lay off staff, raise prices on their goods, or potentially shut down altogether if they can't make enough money to stay afloat.

"To say it more succinctly, 2023 is going to be the survival of the fittest," Gray said.

Taylor Wallace, the owner of Florida-based Paws 'n' Rec — a membership-based doggy daycare and grooming facility — said the Fed's hiking of interest rates are already impacting his business's plans to expand. With nearly half of Americans employed by small businesses, financial hardship to the sector could significantly impact the overall workforce.

"Just since June, the rates have gone up almost 3% so capital is getting a lot more expensive for small businesses generally," Wallace told Insider. "I can't say it's had an immediate direct impact, but especially as we're doing this build out right now, it's going to start having one."