How the Fed Fights Inflation With Interest Rates

In March 2022, U.S. inflation was running at 8.5%, the fastest price increases in 40 years. Over the next 16 months, the Federal Reserve raised its benchmark interest rate 11 times, from near 0% to over 5%, the fastest rate-hiking campaign in decades. By mid-2023, inflation had cooled to around 3%. That single policy lever, the interest rate, is one of the two main tools governments and central banks use to steer an entire national economy. This lesson looks at both tools and how they're actually used.

By the end of this lesson, you will be able to: 1. Distinguish between fiscal policy (government spending and taxation) and monetary policy (central bank interest rates and money supply). 2. Explain how raising or lowering interest rates affects inflation and economic growth. 3. Describe a real historical example of each type of policy in action. 4. Evaluate the trade-offs policymakers face when trying to control inflation without causing a recession.

Macroeconomic policy is how governments try to manage the overall health of a national economy, controlling inflation, unemployment, and growth. There are two main levers. Fiscal policy is controlled by elected governments, like Congress and the President in the U.S., through spending and taxes: spend more or tax less to stimulate a slow economy, or spend less and tax more to cool an overheated one. Monetary policy is controlled by a central bank, the Federal Reserve in the U.S., independent from elected officials, through interest rates and the money supply: lower rates to encourage borrowing and spending, or raise rates to discourage it and cool inflation.

When inflation surged after the COVID-19 pandemic, driven by supply chain shortages, strong consumer demand, and trillions in pandemic relief spending, the Federal Reserve responded with monetary policy. It raised the federal funds rate from a range of 0%-0.25% in March 2022 to 5.25%-5.50% by July 2023. Higher rates make borrowing more expensive: mortgages, car loans, and business loans all cost more, so people and companies spend and invest less, which slows demand and, in theory, price growth. The trade-off is real: higher rates also risk triggering a recession and job losses, which is why the Fed's decisions are watched so closely.

In March 2020, as COVID-19 shut down large parts of the economy, Congress passed the CARES Act, about $2.2 trillion in fiscal stimulus, including direct payments to individuals, expanded unemployment benefits, and loans to businesses. This was fiscal policy: government spending decisions made through legislation, aimed at keeping households and businesses afloat during a sudden economic shock. Unlike monetary policy, this required Congress to pass a law and the President to sign it, a much slower process than a Federal Reserve rate decision, but one that can target specific groups, like a particular industry or income level, in ways interest rates cannot.