Why Does the Federal Reserve Raise Interest Rates?

Why Does the Federal Reserve Raise Interest Rates?
The Fed raises interest rates to meet its overall goals.

Monetary Policy

The Fed does not do anything, including raising interest rates, that does not further the goals of its monetary policy. The Fed has six main goals, according to "Bank Management and Financial Services": ensuring price stability, high employment, economic growth, financial market and institution stability, interest rate stability and foreign-exchange market stability. All of the goals, including interest rates, are connected, so a change in one can affect the others.

Interest Rate Definition

Before tackling increases and decreases, it's important to understand what interest rates are. According to the Federal Reserve Bank of New York, a simple definition of interest rates is the price a borrower pays to use a lender's money for a predetermined period of time. When the borrower repays the loan, he pays the original amount he borrowed--the principal--as well as the interest. For example, if a person borrowed $1,000 at 10 percent interest for one year, he would have to repay the lender $1,100. The fact that a lender will eventually get back more than he lends is his motivation for letting someone else use his money.

The Fed and Interest Rates

Strictly speaking, The Federal Reserve is only in charge of the interest rate that banks charge other banks for borrowing funds over short periods, known as the federal funds rate.

In practice, the Fed has a much greater influence. Because the federal funds rate affects how much it costs a bank to borrow money, a bank passes any increases onto its own borrowers. Therefore, if the Fed sets a high federal funds rate, it is in effect ensuring that banks will also raise rates for their clients--both consumers and businesses.

Raising Rates

When the Fed raises interest rates, it usually does so to control inflation. When rates are low, it is easy for consumers and businesses to borrow money, which increases economic growth. However, because there is so much money being spent, prices often go up as well. If the Fed leaves interest rates too low for too long, inflation is likely to take hold. Therefore, if the Fed determines that the economy is growing well and an interest rate hike will not overly curb growth, it will increase the federal funds rate to avoid prices rising out of control.

Increments

A small increase in interest rates can have a profound effect, so normally the Fed only lowers or raises rates by very small increments. Usually, it will raise or lower rates by a quarter of a percent at a time. A change of a half percent or higher is rare, but not unprecedented in a time of economic uncertainty.