The Fed, explained: What it's trying to do and why it matters to you

By Jeffry Bartash

Interest rates affect the lives of Americans every day

Soft landing? R-star? Restrictive monetary policy? All these terms used by the Federal Reserve are enough to give anyone a headache. But don't be fooled: They matter to you and your money every day.

When top Fed officials meet again this week, they are widely expected to reduce U.S. interest rates.

Here's a glossary of terms to explain what the Fed is trying to do and why.

Soft landing

The Fed's ultimate goal is to slow an overheated and inflation-prone economy without causing a recession. Economists refer to that as a "soft landing" or "landing the plane."

It sounds easy, but it isn't. Almost every time the Fed sharply raises interest rates, a recession ensues. Only once or twice since World War II has the Fed achieved a fabled soft landing.

Monetary policy

Monetary policy is just a fancy term for the process of raising or lowering interest rates to influence the economy. The Fed has other tools at its disposal, but interest rates are the hammer.

Now that inflation has waned, the Fed plans to lower rates quickly over the next year.

Put another way, the Fed is taking its foot off the brakes on the economy - and stepping on the gas.

Dual mandate

The Fed is required by law to keep both inflation and unemployment low. Economic nirvana, in other words.

Historically, it's been a tough balancing act. Low unemployment, for example, has often been linked to higher inflation. Thankfully, that hasn't been the case for at least the last decade.

Accommodative policy

Monetary policy is viewed as "accommodative" when interest rates are low enough to speed up the economy.

Think of all the people who rushed to buy homes a few years ago when mortgage rates fell to a record low. Car sales also surged in an era of near-0% auto loans.

The Fed became very "accommodative" during and after the pandemic to stave off a crisis. All of that spending boosted the economy.

Restrictive policy

Restrictive monetary policy means interest rates are so high that the economy grows slower than what it is capable of.

The Fed jacked up interest rates in 2022 and 2023 to try to tame the worst bout of inflation in 40 years. Inflation tends to slow when the economy does.

The effect of high rates was most visible in the housing market: Home sales and construction fell into a deep funk when mortgage rates soared to 7%.

R-star or neutral rate

The r-star is not some newly discovered astrological body. It's the term Fed insiders use to describe a neutral short-term interest rate that neither helps nor hurts the economy.

At this ideal rate, the U.S. would enjoy low unemployment, low inflation and a steadily growing economy.

What is the r-star rate? It's always been a moving target. But for now, the Fed pegs the ideal short-term interest rate at 2.8%.

Why should this matter to you? The estimated r-star rate tells us how much the Fed is likely to cut interest rates in the next few years.

That could give you a good idea of how much mortgage rates or other lending rates will decline.

The Fed's current benchmark rate is 5.25% to 5.5%. Were the Fed to lower the rate to 2.8%, it would signal that most U.S. interest rates should fall by at least 2 percentage points or more.

-Jeffry Bartash

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09-16-24 1516ET

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