The primary job of theFederal Reserveis to control inflation while avoiding arecession. It does this withmonetary policy. To control inflation, the Fed must usecontractionary monetary policyto sloweconomic growth. The Fed's ideal inflation rate is around 2%—if it's higher than that, demandwill drive up prices for goods.
The Fed can slow this growth by tightening themoney supply. That's the total amount of credit allowed into the market. The Fed's actions reducetheliquidityin the financial system, making it become more expensive to get loans. It slows economic growth and demand, which puts downward pressure on prices.
Key Takeaways
- The Fed’s annual target inflation rate is 2% over time.
- Monetary tools contract or expand the money supply.
- These tools include the federal funds rate, open market operations, and the discount rate.
- Managing people’s inflation expectations is another important tool.
Tools the Federal Reserve Uses To Control Inflation
The Fed has several tools it traditionally uses to tame inflation. It usually uses open market operations (OMO), the federal funds rate, and the discount rate in tandem. It rarely changes the reserve requirement.
Open Market Operations (OMO)
The Fed's first line of defense isOMO. The Fedbuys or sells securities, typically Treasury notes,from itsmember banks. Itbuys securities when it wants them tohave more money to lend. It sells thesesecurities, which the banksare forced to buy. That reducesthe Fed's capital, giving them less to lend. As a result, they can charge higherinterest rates. That slows economic growth and mops up inflation.
Fed Funds Rate (FFR)
Thefed funds rate (FFR) is the most well-known of the Fed's tools. It's also part of its OMO. The FFR is the interest rate banks charge for overnight loans they make to each other. It has the same effect as changing the Reserve requirement and is easier for the Fed to modify.
Discount Rate
TheFed also changes thediscount rate. That's the interest rate theFed charges to allow banks to borrow funds from theFed'sdiscount window.
Reserve Requirement
The reserve requirement was the amount banks were required to keep in reserve at the end of each day. Increasing this reserve kept money out of circulation. Changing the fed funds rate has the same impact as adjusting the reserve requirement. The Fed eliminated the reserve requirement, effective March 26, 2020.
Managing Public Expectations
Former ChairmanBen Bernankenoted that public expectations of inflation are an important influencer of the inflation rate. Once people anticipatefuture price increases, they create a self-fulfilling prophecy. They plan for future price increases by buying more now, thus driving up inflation even more.
The Fed's history of responding to inflation gives you an insight into what may work and what doesn't. Bernanke said the mistake the Fed made in controlling inflation in the 1970s was its go-stop monetary policy. It raised rates to combat inflation, then lowered them to avoid recession. Thatvolatilityconvinced businesses to keep their prices high.
History of the Fed's Response to Inflation
Fed Chairman Paul Volcker raised rates to end the instability. He kept them there despite the 1981 recession. That finally controlled inflation because people knew prices had stopped rising.
Note
Thepast fed funds fatetells you howtheFed managed the expectations of inflation.
The next chairman,Alan Greenspan, followed Volcker's example. During the2001 recession, theFed loweredinterest ratesto end the recession. By mid-2004, it slowly but deliberately raised rates to avoid inflation.
After the2008 financial crisis, theFed focused on preventing another recession. During the crisis, the Fed created many innovative programs. It quickly pumped tens of billions of dollars of liquidity to keep banks solvent.
Many were worried that this wouldcreate inflationonce the global economy recovered. But theFed created an exit planto wind down the innovative programs and endedquantitative easingand its purchases of Treasurys.
How Well the Fed Is Controlling Inflation Now
During the 2020 pandemic, the Fed had to ramp up its quantitative easing and reduce interest rates to combat the swift onset of a recession. The federal funds rate dropped to 0%-0.25% and helped buoy the economy. By 2021, the economy showed strong signs of recovery. However, toward the end of the year, inflation rose to levels not seen since 1990.
In 2022, the Federal Reserve began raising rates in order to tame inflation and plans to continue to do so throughout the year.
Frequently Asked Questions (FAQs)
How does raising interest rates curb inflation?
Raising interest rates increases the costs of borrowing, and that reduces inflation by slowing the economy. When rates go up, fewer people take out loans for things like buying a home or starting a business. In theory, as demand slows for homes, employees, and other goods and services, prices will fall.
Who controls inflation in India, Japan, and other countries?
Many countries have central banks like the Federal Reserve. These banks use monetary policy operations to maintain price stability. For example, the Reserve Bank of India is that country's central bank. There's also the Bank of Japan. The European Central Bank manages monetary policy across the European Union.
