its highest rate in 40 years,

the Federal Reserve is expected to raise interest rates

several times in 2022.

This is Fed chairman Jerome Powell

on what will be needed to ensure a long economic expansion.

- That's gonna require the Fed

to tighten interest rate policy

and do our part in getting inflation back down

to our 2% goal.

- [Narrator] The way the central bank does this

is by changing the federal funds rate,

its main tool for managing the economy.

You can see on this chart that the rate was lowered

to nearly 0% in 2020 to boost the economy

at the beginning of the pandemic.

- There is an important job for us to move away

from these very highly simulative monetary policy settings.

- [Narrator] Adjustments to the federal funds rate

influence a range of borrowing costs,

from how much you own your credit card to mortgage rates.

They also shape broader decisions made by companies,

like how many people to hire or whether to raise prices.

Here's how the federal funds rate works

and how just one rate can guide the entire economy.

- The Fed meets every six or so weeks,

and they're looking at a range of economic data

at those meetings,

but they have two main goals.

One is to ensure stable prices and low inflation.

And the other is to make sure

that the layer market is strong.

- [Narrator] Nick Timiraos covers how the fed guides

the economy through crises.

He says, you can think of the economy

as a car and the fed as the driver.

- They wanna make sure

that the economy's not growing too slow.

And when it is, they'll push on the gas

but they also wanna make sure that it's not going too fast.

And so they'll slow the economy down

by pressing on the break.

- [Narrator] This is where the federal funds rate comes in.

- When you hear on the news

about the fed raising interest rates

or cutting interest rates,

what they're actually deciding to do

is to raise or to lower the federal funds rate.

- [Narrator] This is the interest rate

that banks charge each other to borrow money overnight,

but there's a catch.

The federal funds rate

isn't directly set by the federal reserve.

So in order to influence it,

the fed uses a couple of other tools to set a target range.

These tools are rates that the fed controls in its role

as a bank for banks.

Here's the target range that was in place during 2021.

The federal reserve sets an upper limit and a lower limit

with the goal of keeping the effective federal funds rate

somewhere in between.

The upper limit is determined

by interest on reserve balances.

This is the rate of interest a bank gets on deposits

known as reserves that it keeps at the federal reserve.

The lower limit is determined

by overnight reverse repurchases.

These are securities like treasury bills,

but the federal reserve lends to banks usually for a day

while paying interest.

On this chart, you can see where the fed

has set the target range between the two yellow lines,

the blue line, which is the effective federal funds rate

set by banks sits between the upper and lower limits

as the target range changes

the effective rate goes up or down with it

- So far they've had very successful control

over guiding the federal funds rate

and guiding all short-term money market rates

to where they generally are trying to move them.

- [Narrator] The fed makes these adjustments

in fairly small increments.

Its rate increases for 2022 are expected to only change

by about a quarter to half of a point at a time.

So how can these tiny adjustments for banks

help cool down the entire economy?

It all has to do with how those rates

ripple through the system.

As banks are charged more to borrow,

they'll in turn charge their customers more,

affecting the cost of existing loans

and demand for new borrowing.

The goal of raising these rates is to drive down demand.

- Inflation results when supply and demand are outta whack.

The fed can't do anything to increase the supply of oil

or to increase the number of houses for sale.

The supply side is something out of their reach,

but they can bring supply and demand by reducing demand.

- [Narrator] Here's how rates can influence demand

and inflation.

When rates are low, more people in businesses

are likely to take out loans.

Higher demand for goods and services,

as well as lower rates allows employers

to open more positions to meet demand

and raise wages to appeal to potential employees.

Consumers then turn around

and spend those wages on goods and services,

which in turn can lead to more jobs and higher prices.

The opposite happens when rates are higher.

Fewer people and businesses take out loans,

job growth slows, and spending decreases.

Higher interest rates may also make it more appealing

to save.

Inflation slows as supply and demand balance out.

While interest rates can be effective

in bringing inflation down,

a rate hike could take some time to make an impact.

- Think about your own life

as you go through making different decisions

about whether to buy a house and how big of a house to buy.

It may take a while for this

to ripple through the housing market, for example,

but in 6 or 12 months, we could begin to see, you know,

less demand if interest rates are high enough

to slow interested consumers.

- [Narrator] But while inflation may take time to come down,

consumers and businesses will likely feel the impact

of higher interest rates on loans, mortgages,

and credit cards right away.