Why Does the Fed Change the Interest Rate?

By: Sarah Gleim  | 

Jerome Powell
U.S. Federal Reserve chair Jerome Powell spoke at a news conference on interest rates, the economy and monetary policy actions, at the Federal Reserve Building June 15, 2022, where he announced an interest rate increase of 0.75 percentage points. OLIVIER DOULIERY/AFP via Getty Images

The Federal Reserve raised interest rates for the second time in a row by 0.75 percentage points July 27, 2022. It was the fourth interest rate hike in just five months, and came at the conclusion the Fed's July monetary policymaking meeting. They made the decision to attempt to relieve historic inflation. But what do these back-to-back increases mean for the average American who has a credit card, mortgage or bank account?

First let's discuss the Federal Reserve System. The Fed is the central bank of the United States. There are three bodies that make up the Fed:

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  1. the Federal Reserve Board of Governors (Board of Governors): the governing body of the Federal Reserve System; it oversees the operations of the 12 Reserve Banks; Jerome Powell is the current Federal Reserve chairman.
  2. the Federal Reserve Banks: 12 regional Federal Reserve Banks hold federal funds
  3. the Federal Open Market Committee (FOMC): body of the Federal Reserve System that sets national monetary policy; these operations affect the federal funds rate.

The entire Federal Reserve is responsible for the operation of the U.S. economy and to do that, it performs five key functions:

  1. oversees the U.S. monetary policy to promote employment, stable prices and reasonable long-term interest rates
  2. helps stabilize the U.S. financial system to minimize systemic risks in the U.S. and abroad
  3. promotes dependable individual financial institutions and monitors their impact on the entire U.S. financial system
  4. fosters payment system safety and efficiency to the banking industry and the U.S. government
  5. supports consumer protection via research and analysis, community economic development activities, and the administration of consumer laws and regulations

The Federal Reserve is not funded by Congress. Instead, it's funded by the interest earned on securities it buys, plus fees it receives for services it provides to banking institutions, including check clearing and fund transferring. All net earnings of the Federal Reserve Banks are transferred to the U.S. Treasury.

So what do these have to do with raising interest rates?

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The Effects of Changing Interest Rates

fed structure
The Federal Reserve is responsible for the operation of the U.S. economy. Federal Reserve

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."

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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."

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Originally Published: Mar 26, 2008

Lots More Information

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  • Blank, D. Brian. The Conversation. " 5 things to know about the Fed's biggest interest rate increase since 1994 and how it will affect you." June 15, 2022. (June 16, 2022) https://theconversation.com/5-things-to-know-about-the-feds-biggest-interest-rate-increase-since-1994-and-how-it-will-affect-you-185008
  • Board of Governors of the Federal Reserve. "Transcript of Chair Powell's Press Conference June 15, 2022." June 15, 2022. (June 16, 2022) https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20220615.pdf
  • Board of Governors of the Federal Reserve. "Transcript of Chair Powell's Press Conference July 27, 2022." July 27, 2022. (July 27, 2022) https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20220727.pdf
  • Board of Governors of the Federal Reserve. "About the Fed." May 23, 2022. (June 16, 2022) https://www.federalreserve.gov/aboutthefed.htm
  • Board of Governors of the Federal Reserve. "Structure of the Federal Reserve System." Sept. 10, 2021. (June 16, 2022) https://www.federalreserve.gov/aboutthefed/structure-federal-reserve-system.htm
  • European Central Bank. "Monetary policy decisions." June 9, 2022. (June 16, 2022)https://www.ecb.europa.eu/press/pr/date/2022/html/ecb.mp220609~122666c272.en.html
  • Federal Reserve Education. "Monetary Policy Basics." (June 16, 2022) https://www.federalreserveeducation.org/about-the-fed/structure-and-functions/monetary-policy
  • Horsley, Scott. NPR. "The Fed delivers biggest interest rate hike in decades to combat surging inflation." June 15, 2022. (June 16, 2022) https://www.npr.org/2022/06/15/1105026915/federal-reserve-interest-rates-inflation
  • Russell, Karl and Smialek, Jeanna. The New York Times. "Interest Rates Rise Around the World, as War and High Inflation Grind On." June 16, 2022. (June 16, 2022) https://www.nytimes.com/interactive/2022/06/16/business/economy/global-interest-rate-increases.html
  • Sullivan, Becky. NPR. "Who are the winners and losers of the Fed hiking interest rates?" June 15, 2022. (June 16, 2022) https://www.npr.org/2022/06/16/1105397522/who-are-the-winners-and-losers-of-the-fed-hiking-interest-rates

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