What makes the Federal Reserve decide to raise or lower interest rates?

When the Federal Reserve decides to raise or lower the federal funds rate, it makes headlines – and for good reason. Even small rate adjustments affect the cost and availability of credit, sending ripples through the country’s larger economy. But what exactly is the Federal Reserve, and why does it adjust rates in the first place? Read on for a full breakdown, including how the federal funds rate functions as a powerful lever in the U.S. economy.

What is the Federal Reserve?

The Federal Reserve (Fed) is the central bank of the United States. Established in 1913 through the Federal Reserve Act, it comprises 12 Federal Reserve Banks, the Federal Reserve Board of Governors and the Federal Open Market Committee (FOMC). The three arms work together to carry out the following five functions:

With regard to the Fed’s most visible function – conducting monetary policy – Congress has tasked it with a dual mandate to maintain maximum employment and stable prices in the United States. Current Fed Chair Jerome Powell (as of January 5, 2026) has been consistently vocal about his commitment to the central bank’s “unchanging foundation of our mandate from Congress,” even against the backdrop of the Fed’s “ever-evolving understanding of our economy.” Speaking specifically to the Fed’s dual mandate, Powell said the following in September 2025: “Our success in delivering on these goals matters to all Americans. We understand that our actions affect communities, families and businesses across the country.”

On the price stability front, the Fed’s goal is an annual inflation rate of 2%. Full employment, however, isn’t as easy to gauge. Instead of relying on a single figure to inform its decisions, the Fed considers a broad set of labor market indicators to determine what qualifies as maximum employment at any given moment.

Why does the Fed change interest rates?

One of the main tools the Fed uses to achieve its dual mandate is the federal funds rate – the interest rate banks charge each other for borrowing money overnight to meet their reserve requirements. (Reserves refer to both the amount of cash a bank has physically on hand and its deposits with a central bank.) When the Fed makes changes to this rate, financial institutions follow suit, which impacts the cost of all credit products (e.g., mortgages, car loans, personal loans, business loans, credit cards, etc.).

In turn, changes to the cost of credit products affect the spending behavior of U.S. households and businesses. Knowing this, the Fed adjusts the federal funds rate to steer economic activity as needed to achieve its goals.

What leads the Fed to raise interest rates?

The Fed raises interest rates when it needs to tighten monetary policy. One of the main reasons it does so is to combat high inflation. For example, the Consumer Price Index (CPI) surged in 2022, hitting a 40-year high of 9.1% in June of that year – far above the Fed’s 2% inflation target. To stop and reverse the surge, the Fed implemented 11 rate hikes over a period of about a year and a half, increasing the federal funds rate by around 5% total. The action worked in bringing the CPI down to approximately 3%, where it has remained since. The FOMC also raises rates in response to factors that signal economic vitality, including a strong labor market, wage growth and expanding economic activity.

What leads the Fed to lower interest rates?

The Fed lowers interest rates when it needs to ease monetary policy – primarily to stimulate the economy and prevent or soften a recession. Among the key factors that can lead to cuts are rising unemployment, a weak labor market and subdued inflation. In March 2020, for example, the FOMC dropped the federal funds rate to a target range of 0% to 0.25% in response to severe economic disruption brought on by the first U.S. wave of the COVID-19 pandemic. The rate remained at 0% to 0.25% until rate hikes were needed to calm surging inflation in 2022.

The Fed’s decision-making process when it comes to raising and lowering interest rates

The FOMC is the 12-member monetary policymaking arm of the Federal Reserve. It consists of the seven members of the Federal Reserve Board of Governors, the president of the Federal Reserve Bank of New York and four other Reserve Bank presidents (who serve one-year terms).

The group meets at least eight times a year to review economic and financial data and to decide on monetary policy actions. Its primary responsibilities include setting the target federal funds rate and directing open market operations, such as the buying and selling of U.S. government securities.

After each meeting, the FOMC releases a written statement outlining its decisions, including interest rate adjustments and the purchase or sale of securities to control the U.S. money supply. This statement is often accompanied by a press conference.

Key economic indicators the Fed monitors to make rate decisions

The Fed monitors a wide range of economic indicators to determine whether it will raise, lower or hold interest rates. Here are the most notable and how they’re tracked:

Impact of Fed rate decisions

While the FOMC’s decisions regarding the federal funds rate directly influence short-term interest rates, the effects don’t stop there. In fact, U.S. monetary policy can be quite far-reaching, impacting stock and bond prices, longer-term interest rates and even the U.S. dollar’s exchange rate.

Bond prices, for example, have an inverse relationship to interest rates. When market rates fall, the value of existing fixed-rate bonds increases, and vice versa. Stock prices can also take a hit when rates increase, since higher borrowing costs often weigh on corporate profits and reduce investor appetite for risk.

Globally, rising U.S. rates tend to strengthen the dollar, reduce U.S. demand for imports and tighten financial conditions abroad. Conversely, when U.S. rates fall, global financial conditions loosen, easing debt burdens and stimulating investment abroad. Rate hikes can be especially challenging for emerging markets that carry large external debts and have limited reserves.

Historic Fed rate decisions and their impact

Below are some of the most historically significant Fed decisions regarding interest rates, along with their impacts.

What’s next for interest rates in 2026?

At its December 2025 meeting, the FOMC cut the federal funds rate for the third time that same year. With the target range now at 3.5% to 3.75%, the hope is that cheaper borrowing will lead companies to hire more workers. This would hopefully give the current job market a boost, especially after the most recent jobs report showed unemployment at 4.6%, a four-year high.

Too-high inflation still lingers, however, which is why Powell signaled a likely slowing of rate cuts in 2026, despite the ongoing employment situation. With more data available in early 2026 following the data drought caused by fall 2025’s government shutdown, the Fed will be better equipped to decide whether to fast-track another rate cut or stay the course and watch how things play out.

The bottom line

Think of the Federal Reserve as the wizard behind the curtain of the U.S. economy, quietly pulling levers to maintain balance and stability. One of its most powerful levers is the federal funds rate. When inflation runs too hot, the Fed raises rates to cool it down. When the economy weakens, the Fed lowers rates to drive borrowing, spending and investment.

We saw the latter in action at the tail end of 2025, when the Fed lowered rates three consecutive times in response to a cooling job market. While it’s clearly prioritizing the employment side of its dual mandate – at least in the short term – how the Fed balances its stance on inflation in 2026 remains to be seen. Investors should stay tuned and observe, especially as President Donald Trump prepares to announce a new Fed chair early in the year.

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