How the Fed’s Interest Rate Works and Affects the Economy

It may be the most important tool in the Federal Reserve’s toolkit: the interest rate. And on Wednesday, the Fed wielded it for the first time this year, raising rates by a quarter percentage point in a bid to slow down accelerating inflation. But what does it mean when the Fed raises — or lowers — rates? And how does that affect the economy and all of us? Here’s how to understand it all.

Why the Federal Reserve Wielded Its Key Tool

The Fed really has two main jobs. The first is to ensure that prices remain stable, which generally means inflation that is neither too hot, nor too cold. The second job is to strive for an economy with maximum employment — meaning ensuring the labor market is growing at a healthy pace and people who want jobs can find them.

There are times when things are clicking in the economy and both of the two Fed mandates are at peace with each other. Inflation is just at the right temperature, meaning everyday prices are not rising too much, while the labor market is growing steadily, meaning people who want work can find them. But more often than not, the Fed finds itself in a situation where it has to focus on one of the two — or worse: Both inflation and the labor market are flashing warning signs and policy makers have to confront the agonizing choice of which one to focus on first.

The Fed has several tools at its disposal to try to influence the economy — but none is more important than the interest rate. When inflation is running hot, the Fed typically springs into action by raising interest rates — just like it did this week. Although the Fed doesn’t directly control what firms charge for mortgages or credit cards, it’s hoping that by raising its own interest rate, it can lead to a domino effect across the economy that can then push up many kinds of borrowing costs across the economy. It’s the equivalent of applying the brakes on the economy. The main goal is to try to cool down prices by trying to get people and businesses to think more carefully about their spending. People might think a little harder about whether to buy a home if mortgage rates are higher — or whether to take that business loan if banks are charging more.

US Federal Reserve raises interest rates for first time since 2023

The Federal Reserve operates under a dual mandate: keeping prices stable by preventing inflation from running too hot or too cold, and fostering maximum employment where workers who want jobs can find them. When those two goals conflict, policymakers face tough choices. Inflation has spent five years above the central bank’s 2% target, prompting the central bank to act.

“The plain fact is that inflation is too high and has been for too long.”

Kevin Warsh, Fed Chair

While the Fed does not directly set the prices banks charge consumers for mortgages or credit cards, adjusting its benchmark interest rate triggers a wider economic domino effect. Raising rates acts as a brake on financial activity, encouraging households and businesses to reconsider major purchases or business loans.

Economic Impact on Mortgages and Consumer Debt

Borrowing costs were already creeping upward in anticipation of policy shifts.

On the flip side, when the Fed is concerned about the labor market and wants to push up economic activity, it cuts interest rates in the hopes that the opposite will happen. It’s the equivalent of trying to press on the accelerator for the economy.

Contrasting Past Pandemics and Current Resilience

Take what happened during the Covid-19 pandemic— the Fed, then led by Jerome Powell, was concerned that the pandemic would lead to massive layoffs. So Powell and the Fed slashed interest rates to near zero, hoping it would spur financial firms to charge less for loans or mortgages — and thus encourage more spending across the economy. It worked — until inflation began climbing and then the Fed had to do the opposite and start cutting rates.

So why is the Fed raising interest rates now? As Fed Chair Kevin Warsh said Wednesday, The plain fact is that inflation is too high and has been for too long. Inflation has run above the Fed’s 2% target for five years, and the central bank is not confident it would cool off without higher interest rates. Warsh also made the case that it’s the right moment to act with the economy strong enough to absorb the impact of what is ultimately a modest interest rate hike. Consumer spending has been growing even as higher prices continue to pinch many households. And the job market appears to be on solid footing to weather higher borrowing costs without triggering a surge in layoffs.

So what happens now in the economy – and our pocketbooks? The Fed’s rate hike is small enough that it shouldn’t have a dramatic effect — but it does come as many borrowing costs are already rising, partly in anticipation of higher interest rates.