Why Does the Fed Change the Interest Rate?

The Federal Reserve uses interest rates to fight inflation, which is currently at a 40-year high. As part of its mandate, the Fed is obligated to maximize employment and keep prices stable. When the economy and job market are both strong — as they are now — the Fed can focus on reducing inflation.

"The Fed's monetary policy actions are guided by our mandate to promote maximum employment and stable prices for the American people," Federal Reserve chairman Jerome Powell said in a July 27, 2022, press statement. "My colleagues and I are acutely aware that high inflation imposes significant hardship, especially on those least able to meet the higher costs of essentials like food, housing, and transportation. We are highly attentive to the risks high inflation poses to both sides of our mandate, and we are strongly committed to returning inflation to our 2 percent objective."

The problem is, inflation is currently so high, to reduce it could require the highest interest rates in decades, which could weaken the economy, according to reporting by The Conversation.

Still how does raising interest rates help reduce inflation? Raising short-term interest rates increases borrowing costs for banks. They pass those costs on to consumers and businesses in the form of higher rates on long-term loans. That essentially makes everything more expensive. But that's the goal: to reduce consumer demand, which has overwhelmed supply. Higher rates will make it more expensive for consumers to have credit cards, student loans, or home and car loans.

So is this all bad news? In the short term, perhaps. The Fed is trying to slow inflation without causing a recession — what's known as a "soft landing." But much of the factors driving current inflation are beyond the Fed's control, including things like the surge in crude oil prices and other commodities resulting from Russia's invasion of Ukraine, as well as pandemic-related lockdowns in China, which exacerbated supply chain disruptions.

"Our objective really is to bring inflation down to 2 percent while the labor market remains strong," Powell said June 15, 2022. "I think that what's becoming more clear is that many factors that we don't control are going to play a very significant role in deciding whether that's possible or not."

Inflation is soaring globally, and so far in 2022, at least 45 countries have raised interest rates to help combat it, including Brazil, Saudi Arabia, Switzerland and England. The European Central Bank announced June 9, 2022, that it would also raise its key interest rates by 25 basis points at its July meeting.

If the Fed can achieve a soft landing and reduce inflation without a recession, that would be good news for everyone in the long term. Powell remains hopeful. "We're trying to do just the right amount. We're not trying to have a recession and we don't think we have to," Powell said July 27, 2022. "We think that there's a path for us to be able to bring inflation down while sustaining a strong labor market."