How (and Why) the Federal Reserve Sets Interest Rates
August 22, 2025
The Fed’s Dual Mandate
The Federal Reserve has two main goals they shoot for to keep the U.S. economy humming along:
- Keep inflation near 2%
- Maintain maximum employment (as long as it doesn’t push inflation above that 2% target)
The federal funds rate is the Fed’s primary tool for managing both of those.
When the Fed Lowers Rates
If prices are rising too slowly (like much of the 2010s), the Fed cuts rates to encourage growth. Lower rates make it cheaper to borrow, prompting banks to lend and businesses and consumers to spend. The goal? More economic activity.
When the Fed Raises Rates
If prices are climbing too quickly (like after the pandemic), the Fed hikes rates to cool things down. Higher borrowing costs slow business investment and consumer spending, often leading to a rise in unemployment but also helping to rein in inflation.
More Than Just Inflation and Jobs
The Fed doesn’t stop at just those two data points though. It also considers housing starts, consumer spending, GDP, and a wide range of indicators to understand the broader economy before making rate decisions.
What This Means for Mortgages
Although the Fed funds rate doesn’t directly set mortgage rates the way it does for credit cards or auto loans, mortgage rates are closely tied to broader economic trends and investor expectations, both of which are heavily influenced by the Fed’s moves. So a rate increase or a rate cut can often push mortgage rates in the same direction.
Final Thoughts
The Fed’s rate decisions ripple through the entire economy, shaping everything from job markets to mortgage affordability. Whether rates are heading up or down, their choices are always aimed at keeping inflation in check while supporting a healthy labor market.
