Key takeaways:

  • The Federal Reserve’s mission is to keep unemployment low and prices stable.
  • It took drastic steps to accomplish that mission when the COVID-19 pandemic first broke out.
  • Now it’s reversing those policies as gently as possible — but the economy is likely in for more turbulence.

If you’ve read anything about financial markets or the economy in recent months, you probably know that the Federal Reserve – the central bank of the United States – has been raising interest rates, and it’s causing all kinds of disruptions in everything from mortgages to jobs.

But there are a lot of misconceptions out there about the Federal Reserve (Fed). Many people struggle to understand what the central bank is doing and why they should care. In this article, we’ll attempt to demystify all that, and explain how the central bank’s actions impact you.

Two responsibilities

The Federal Reserve was created in 1913 with a two-part mission: to maximize employment and to keep prices for goods and services stable — to keep a lid on inflation, in other words. As the country’s central bank, the Fed accomplishes those objectives by controlling the supply and flow of money around the economy.

That may sound complicated, but the past few years offer a real-time picture of exactly how the supply of money can impact the economy. Think back to March 2020, when the COVID-19 pandemic first exploded. Around the country, lockdown orders and stay-at-home policies put millions of Americans out of work in just a few weeks.

The Fed responded by slashing interest rates, the easiest and bluntest tool it has for managing the money supply. Money became “looser,” or easier to borrow. That step was intended to help any small-business owner who needed a loan to stay afloat, for example, or anyone out of a job who wanted to start a business. 

Impact on mortgage rates

It’s important to note that the interest rates controlled by the Fed are the ones that govern how much banks pay each other, not the ones that touch consumers directly. So it’s a misnomer to say that the Fed cut mortgage rates. But in financial markets, many types of assets move in tandem with each other. So when the Fed cut its benchmark rate in 2020, borrowing costs for mortgages quickly followed.

The plunge in mortgage rates was enormously helpful in stabilizing the economy: real estate agents, appraisers, moving companies, construction workers, and mortgage lenders did gangbusters business for the next two years straight. 

What’s more, as home prices shot up, many Americans found themselves with more accrued home equity than they ever imagined, helping many afford big purchases like renovations and education. Higher property values helped state and local governments collect more in taxes. And so on. 

Fed shifts to reverse

But at some point, the Fed’s easy-money policies became, well, too easy. With so many people desperate to buy property, home prices surged. That same dynamic repeated itself in other areas of the economy, pushing inflation higher and higher. More importantly, at some point there was no longer a need for the crisis-era policies from 2020. So now the central bank is moving in reverse.

Raising interest rates dampen demand, as anyone who spent 2022 trying to buy or sell a home can well attest. And not just for consumers: businesses are less likely to borrow to expand their operations.

That’s where the Fed’s policies become a bit uncomfortable. It’s not healthy when the economy is growing too fast. Just ask anyone who’s lost a bidding war to someone willing to spend tens of thousands of dollars over a home’s listing price. But it’s quite another thing when the cost of borrowing gets so high that people simply cannot move or realize the American Dream — or that some may lose their jobs.

Unemployment forecast

The Fed knows this, of course. Its members are themselves forecasting a higher unemployment rate in 2023 than in 2022. The good news is that the highest rate they forecast is still much lower than the long-term historical average. The bad news is that any increase in unemployment means pain for individual households.  

Professional investors use the expression “soft landing” to try to describe what the Fed is attempting to do: steer the economy gently toward a slower pace of growth, with minimal bumpiness. It’s a very tall order, and history shows the Fed rarely accomplishes it. It’s also why so much attention gets paid to what the Fed is doing now: there’s a lot at stake. 

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