The Fed’s interest rate hike is bound to raise borrowing costs across the economy — but it’s intended to help bring down inflation.
LM Otero/AP
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LM Otero/AP
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.
So what does the Fed actually do?
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.
So how does the Fed accomplish its goals?
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.
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.
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 raising 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.
In a news conference after the Fed raised rates, Kevin Warsh called inflation “too high.”
Win McNamee/Getty Images North America
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Win McNamee/Getty Images North America
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.
The average rate for a 30-year fixed rate mortgage jumped to 6.95% this week, almost two-tenths of a percent higher than a week earlier, according to mortgage giant Freddie Mac data out on Thursday.
That’s enough to increase the cost of a standard home loan by hundreds of dollars each month and further stall hopes of a recovery for the country’s stagnant housing market.
“It’s like that Godfather movie,” said Kara Ng, senior economist at the real estate company Zillow. “Every time it tries to break out, something pulls it back in.”
A higher interest rate also trickles down to the cost of carrying a balance on a credit card or a Buy Now Pay Later deal, though the moves are not as substantial as with mortgages.
Analysts at LendingTree, an online loan marketplace, estimate that for someone with $7,000 in credit card debt, the Fed’s rate hike would cost just a few extra dollars each month.
But these higher borrowing costs come as Americans have already been struggling with the high cost of living. The Fed, though, is hoping that the added near-term pain to households will be worth it if it can eventually help bring down inflation.
So now what?
This depends on how the economy responds to the Fed’s rate hike — and on forces beyond the central bank’s control, like the war in the Middle East, which is pushing up energy costs such as gas prices.
Any improvement on the cost of living is not likely to happen quickly. In fact, the Fed’s rate-setting committee signaled a plan to raise rates once more this year, before holding steady in 2027.
At the end of the day, there are no quick fixes to inflation — and it may be a while before households see any relief from high prices.
