How Interest Rates Work

The economy is a living, breathing, deeply interconnected system. When the Fed changes the interest rates at which banks borrow money, those changes get passed on to the rest of the economy.

For example, if the Fed lowers the federal funds rate, then banks can borrow money for less. In turn, they can lower the interest rates they charge to individual borrowers, making their loans more attractive and competitive. If an individual was thinking about buying a home or a car, and the interest rates suddenly go down, he or she might decide to take out a loan and spend, spend, spend! The more consumers spend, the more the economy grows.

The opposite is true as well. If the Fed raises the federal funds rate, then other interest rates tend to follow suit. Mortgage rates will tick up and the rates for car loans will rise. All of this will have a "cooling" effect on the economy, since borrowing money at a higher interest rate is less attractive to consumers.

That's why the stock market tends to go up when the Fed lowers interest rates and go down when the Fed raises rates. Those moves are signs to investors that consumers will either be buying more goods and services, or the opposite, that demand is about to slow down. Lower interest rates are doubly good for the stock market, because it makes other investments less attractive. For example, the interest rate paid on U.S. Treasury bonds is closely tied to the federal funds rate. If the funds rate goes down, then bonds and other fixed-rate securities won't pay as much as other, slightly riskier investments like the stock market. The influx of investor money into the stock market will in turn raise stock prices, another indicator of a healthy economy [source: FRBSF].

A lower federal funds rate also decreases the value of the dollar on the foreign exchange market. While a long-term drop in the value of the dollar is bad news for the U.S. economy as a whole, it can be good short-term news for domestic manufacturers. When the dollar goes down, it becomes more expensive to buy goods and services from foreign companies. This encourages companies to buy domestic products, injecting more cash into the economy [source: FRBSF].

Because the Fed's monetary policy decisions have such a powerful influence on the strength and direction of the economy, banks, lenders, borrowers and investors spend a lot of energy analyzing the Fed's every move and word.

For example, long-term interest rates, like those on 30-year home mortgages, have a lot to do with what banks think the Fed will do in the future [source: FRBSF]. If the Fed hints that it will raise interest rates to combat inflation (more on that in the next section), the banks might be worried that the Fed knows something they don't, namely that inflation is on the rise. As we discussed earlier, inflation affects the real interest that a lender earns on a loan. To adjust for the possibility of rising inflation, banks might raise their long-term interest rates.

Now let's talk about how the Fed's interest rate changes can affect inflation.