Ever wonder how the Fed's interest rate actually works? We've got answers

The Fed's interest rate hike is bound to raise borrowing costs across the economy — but it's intended to help bring down inflation. LM Otero/AP hide caption

It may be the most important tool in the Federal Reserve's toolkit: the interest rate.

And on Wednesday, the Fed wielded it for the first time this year, raising rates by a quarter percentage point in a bid to slow down accelerating inflation. But what does it mean when the Fed raises — or lowers — rates? And how does that affect the economy and all of us?

The Fed really has two main jobs. The first is to ensure that prices remain stable, which generally means inflation that is neither too hot, nor too cold.

The second job is to strive for an economy with maximum employment — meaning ensuring the labor market is growing at a healthy pace and people who want jobs can find them.

There are times when things are clicking in the economy and both of the two Fed mandates are at peace with each other. Inflation is just at the right temperature, meaning everyday prices are not rising too much, while the labor market is growing steadily, meaning people who want work can find them.

But more often than not, the Fed finds itself in a situation where it has to focus on one of the two — or worse: Both inflation and the labor market are flashing warning signs and policy makers have to confront the agonizing choice of which one to focus on first.

The Fed has several tools at its disposal to try to influence the economy — but none is more important than the interest rate.