How and Why the Fed Controls Inflation and Interest Rates

Today’s post is about the Federal Reserve-what it does, and why interest rates are such an important part of how it manages the economy.

Let’s start with the basics. The Federal Reserve, or the Fed, is the central bank of the United States. Its main job is to promote a healthy economy. Unlike many other central banks, its goal is not just to stabilize price growth — in other words, to control inflation — but it’s also tasked with maintaining maximum employment.

One of the Fed’s most important tools is its control over short-term interest rates-specifically, the federal funds rate. This is the rate at which banks lend money to each other overnight. It might sound like an obscure rate to care about, but it has a big ripple effect across the economy.

When the Fed raises or lowers this rate, it affects borrowing costs for businesses and consumers. That includes things like credit cards, car loans, mortgages, and business investment. Why? Because if banks can get, say, 5 percent interest in annual terms on lending to each other overnight — loans that are very safe to make — they’re certainly not going to settle for less than that for riskier, longer-term loans.

So how does this connect to inflation?

Inflation is when the overall price level in the economy goes up. A little inflation is normal — 2% per year is the Fed’s official target — but too much unexpected inflation can erode purchasing power, hurt savers, and create uncertainty that slows down economic growth.

When inflation is rising too fast, the Fed raises interest rates. Higher rates make borrowing more expensive, which reduces spending and slows down demand in the economy. As demand cools, price pressures tend to ease.

This doesn’t happen instantly — it takes months for the effects of rate hikes to work their way through the economy. But over time, tighter monetary policy tends to bring inflation down.

On the other hand, when the economy is weak — say during a recession — the Fed lowers interest rates to encourage borrowing and spending. That helps boost demand, reduce unemployment, and keep the economy from stalling out. At the same time, when economic activity increases, inflationary pressure does as well.

The Fed communicates its decisions and expectations through statements and press conferences. These signals matter because many decisions, like how much to invest, lend, and borrow, are fairly long-term commitments. So investors, borrowers, and lenders respond not just to what the Fed does, but to what they think it’s going to do in the future.

The Fed doesn’t just guess when to move rates. It looks at lots of data: inflation trends, job numbers, consumer spending, business investment, and more. Its goal is to find the right balance between supporting growth and keeping prices stable. Raising rates to fight inflation will generally slow growth and increase unemployment. Lowering rates to support jobs can risk fueling more inflation. That’s the tradeoff.

The ultimate goal is a stable, growing economy with prices that don’t spiral out of control.

Originally published at https://mytwocentsandcounting.substack.com.