What does it mean when the Fed raises the interest rate? It helps to first understand how the Fed raises the rate, which may surprise some people. The Fed does not "set" the interest rate as it might, for example, by declaration or edict or by fixing prices. No, it targets a higher interest rate by contracting the money supply until that money supply intersects the market demand for money at a higher market-clearing rate of interest.
How does the Fed reduce the money supply? Typically by conducting open market operations, which is the purchase or sale of government securities by the Fed. To raise the money supply, it purchases new government securities, paying for them by creating--out of thin air--reserves for the commercial banking system. To reduce the money supply, it sells securities which shrinks the amount of deposits in circulation in the economy. In other words, it reduces the liquidity or amount of credit in the system. This is equivalent to reducing aggregate demand for the goods and services in the economy. (Yes, you heard right; an increase in the money supply increases the aggregate demand for goods and services by businesses and consumers.)
Raising interest rates is a contractionary policy decision. It is designed to slow down the economy, reducing output and employment, and raising the equilibrium prices of goods and services in the economy. Why would the Fed choose to contract an already anemic economy? To head off inflation, which has its own set of insidious costs and distortions that significantly hurt the economy.
The Fed has always had to tread a very fine line between increasing the money supply enough in the short run to minimize the depth and length of a recession, but not increasing the money supply so much that it creates inflation in the longer run. Excessive money growth is what causes inflation. And over the last two years, the U.S. has witnessed a record-shattering increase in the money supply as policymakers struggled to deal with an unprecedented financial crisis.
I have been saying for months that this behemoth money supply would inevitably lead to significant inflation unless steps were taken to shrink it. I believe the Fed has now begun to take those steps.