Why do central banks raise and cut interest rates?

STEP 1Central banks and the policy rate

Let's first sort out who decides, what they decide and why. Knowing just these three things lets you read half of all interest rate news.

The central bank sets the benchmark for the “price of money”

In Lesson 12 you learned that an interest rate is the price of borrowing money. But there are many kinds of rates, such as deposit rates, lending rates and corporate bond yields. The starting point for all of them is the policy rate.

The policy rate is the target for the rate that applies when banks lend to and borrow from each other overnight. The US Fed's official explanation says the same. The federal funds rate that the Fed steers is the rate at which banks lend reserves held at the Fed to other banks overnight; when it changes, the effect passes through other short-term rates, exchange rates, long-term rates, and the amount of money and credit, and finally reaches employment, output and prices.

Think from the bank's point of view. When a bank's funding cost goes up, it raises lending rates, and to attract more deposits it raises deposit rates too. In this way the policy rate spreads like a ripple and reaches our bank accounts and loan interest.

The Bank of Korea's Monetary Policy Board and the US Fed's FOMC

The policy rate is set not by one person but by a committee vote. The Korean and US meetings are among the most important dates for investors, so they also appear on the Robin Invest Calendar.

Sources: US Federal Reserve FOMC overview (federalreserve.gov), Bank of Korea and Wikipedia descriptions of the Monetary Policy Board, Bank of Korea Act Article 1. Checked 2026-10-05.

The two central banks' goals differ a little

The US Fed is responsible for both “maximum employment” and “price stability.” This is called the dual mandate. It means that even if prices are high, the Fed may hesitate to raise rates if unemployment is rising fast. The inflation target is 2% a year on the PCE measure you learned about in Lesson 9.

Article 1 of the Bank of Korea Act sets the Bank's purpose as “contributing to the sound development of the national economy by pursuing price stability,” and requires it to also pay attention to financial stability when conducting policy. Its target is the 2% consumer price inflation rate from Lesson 7. Because Korea has a large export share and the won is sensitive to the dollar, in practice it also weighs the exchange rate and household debt heavily. We check this with data in STEP 3.

STEP 2How interest rates cool and warm the economy

Let's follow the pipes the water flows through when you turn the handle and the temperature changes. Then let's become the central bank ourselves and make a decision.

The five steps through which interest rates spread

The fact that there are five steps matters. Loan rates change within weeks, but it takes months for people to actually cut spending and for companies to put off factory investment, and even longer for that to show up in price statistics. This gap between a decision and its effect is called the policy lag. It is commonly put at around a year or more.

That is why central banks try to act on “prices one to two years from now,” not “prices today.” It is also why they look at the leading indicators from Lesson 6, inflation expectations and wage trends together. It is the same reason a shower handle is turned a little at a time rather than all the way. The policy rate usually moves in 0.25 percentage point steps, and only in urgent times by 0.5 or 0.75 percentage points.

See it in a picture: if I were the central bank

Pick the state of prices and the economy. It shows which way the steering needle tilts and when a similar situation actually happened.

Try picking “high prices + weak economy.” The needle wavers in the middle. As with the stagflation in Lesson 10, you would have to raise rates to tame prices and cut them to revive the economy, so whichever you choose has a cost. This is the hardest situation for a central bank.

Neutral rate, hawks and doves

The interest rate level that neither warms nor cools the economy is called the neutral rate. When the policy rate is above the neutral rate it is described as “tight,” and when it is below, “accommodative.” The neutral rate is an invisible estimate, so opinions differ from person to person. This difference splits the committee members' leanings.

Those who worry more about prices and are eager to raise rates are called “hawks,” and those who worry more about the economy and jobs and are eager to cut are called “doves” (hawk / dove). When the news says a “hawkish hold,” it means rates were left unchanged but the bank signaled that it may raise them later.

A central bank conducts policy not only through decisions but also through words. Announcing the likely future direction of rates in advance is called forward guidance. Four times a year the Fed publishes the dot plot, in which each member marks a dot for where they expect rates to go. The market reacts to a single word in the statement or one sentence in the press conference as much as to the rate number itself.

STEP 3The 2022 rate hikes and Korea-US rates

Now let's open the actual record. Seeing when and why the central banks turned the handle shows how the steering wheel from STEP 2 was used in reality.

US: two years of chasing inflation

The blue staircase is the policy rate and the orange line is inflation. During the COVID shock in March 2020, the Fed cut rates to 0–0.25% with two emergency cuts. The economy had gone beyond “weak” and come to a standstill.

Prices rose fast from 2021, but the staircase stayed at the bottom for a while. The Fed saw the price rise as a “transitory” result of supply chain disruptions. After changing its view, the Fed started with a 0.25 percentage point hike in March 2022, raised by 0.75 percentage points four times in a row from June to November, and stopped at 5.25–5.50% in July 2023. That is more than 5 percentage points in 16 months. Over that period inflation peaked at 9.1% in June 2022 and then came down. It is a case of turning the handle late, but hard.

As inflation fell to the 3% range and employment cooled, the Fed started cutting in September 2024 and went down to 3.50–3.75% by December 2025. But when inflation rose again to 4.2% in May 2026, it hiked 0.25 percentage points in September 2026 back to 3.75–4.00%. Loosen the handle before prices fully reach the target and things can heat up again, just like the shower analogy.

Korea: moves first, with an eye on the US

Press the “Korea vs. US policy rate” button above the chart. The Bank of Korea began hiking in August 2021, seven months before the US. It was worried not only about prices but also about financial imbalances such as fast-growing household debt and home prices. This is the Bank of Korea Act's “attention to financial stability” showing up in an actual decision.

In July 2022 the upper bound of the US policy rate (2.50%) rose above Korea's (2.25%), producing a “Korea-US rate inversion.” When US rates are higher, dollar assets become more attractive and put downward pressure on the won, and a weaker won raises import prices and can in turn stoke Korean inflation. That is why the Bank of Korea always keeps an eye on US decisions. Korea stopped at 3.50% in January 2023, cut to 2.50% between October 2024 and May 2025, then hiked back to 3.00% in July and August 2026. As of September 2026, the gap between the US upper bound of 4.00% and Korea's 3.00% is 1 percentage point. You will learn the relationship between exchange rates and rate gaps in detail in Lesson 24.

For stocks: a rate decision shakes both knobs together

Let's put the rate decision into “stock price = earnings × multiple” from Lesson 1.

What matters more in practice than the decision itself is the gap versus what the market expected. If a 0.25 percentage point hike was fully expected, stock prices may actually rise, and if rates are unchanged but the statement is hawkish, stock prices may fall. The principle of reacting to the gap versus expectations is covered separately in Lesson 20. You can see upcoming Monetary Policy Board and FOMC dates on the Calendar, and which sectors the current rate environment favors on the Macro Map.

It is not always so. There have been periods when stock prices rose while rates were being raised because earnings grew fast, and periods when stocks fell even as rates were cut because of recession fears. A rate decision is the starting point for asking, “Which knob will move harder?”