You Decide: Why did the Fed raise its interest rate?

Among the powers of the Federal Reserve (the Fed) is the ability to impact interest rates. The Fed doesn't directly control all interest rates in the economy, but it can directly change an interest rate called the federal funds rate, which is the interest rate charged when one bank borrows from another bank. Still, when the Fed makes changes to its federal funds rate, other interest rates in the economy tend to move in the same direction.

Hence, when the Fed raised the federal funds rate by one-quarter percentage point on Wednesday (Sept. 16), immediately there was the expectation other interest rates in the economy would also increase. In fact, some interest rates had already risen prior to the Fed hike because for weeks the Fed's leaders had been publicly saying they were ready to push up their rate at their next meeting.

Influencing interest rates is one of the significant powers the Fed has to achieve the goals Congress has given this independent agency. Specifically, the Fed's charter stipulates that the agency use its powers to achieve a low unemployment rate as well as a low inflation rate. The national unemployment rate has hovered near 4% for several months. A 4% jobless rate is considered relatively low.

But the inflation rate is another matter. The inflation rate measures the percentage change in the prices of products and services that typical households buy. Usually, the rate is quoted on an annual basis. The Fed's goal is a 2% or lower annual inflation rate. But recently the annual inflation rate has hovered between 3.5% and 4%, obviously well above the 2% goal.

The Fed doesn't have the power to directly reduce price increases. But what it can do is reduce the upward pressure on prices. Specifically, the Fed uses its tools to motivate consumers to slow their buying. With households buying less, the expectation is that sellers will not raise their prices as much.

One of the ways to motivate households to slow their spending is to make borrowing more expensive. Households often borrow in order to spend. Borrowing to buy a home or a vehicle is an example. Consequently, when the Fed raises its interest rate and other rates follow, borrowing and spending slow, and inflation moderates. However, the Fed needs to be careful not to generate such a large consumer spending pullback as to cause a recession.

Using its power to impact interest rates is not uncommon for the Fed. For example, as the country recovered from the pandemic there was a surge in inflation as pent-up consumer buying outpaced production. The Fed significantly raised its interest rate to cool off inflation. Afterward, the Fed gradually lowered its interest rate to make sure economic growth continued. But the stubbornness of today's inflation, partly due to tariffs and the Iran War, ultimately caused the Fed to reverse and push interest rates higher.

The Fed has already indicated another rate hike is coming. So, I would expect higher interest rates at least through early 2027. However, if tariffs are reduced and/or the Iran War is ended, another rate hike may not happen.

Bottom line: Did the Fed have good reasons to increase their interest rate? You decide.

Mike Walden is a Reynolds Distinguished Professor Emeritus at North Carolina State University. His new book, North Carolina in the Anxious Age, will be released by The UNC Press in early October and is now available for pre-order.

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