How the Federal Reserve Controls Inflation

The Way the Fed Uses Its Tools To Manage Prices

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The primary job of the Federal Reserve is to control inflation while avoiding a recession. It does this with monetary policy. To control inflation, the Fed must use contractionary monetary policy to slow economic growth. The Fed's ideal inflation rate is around 2%—if it's higher than that, demand will drive up prices for goods.

The Fed can slow this growth by tightening the money supply. That's the total amount of credit allowed into the market. The Fed's actions reduce the liquidity in 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 is OMO. The Fed buys or sells securities, typically Treasury notes, from its member banks. It buys securities when it wants them to have more money to lend. It sells these securities, which the banks are forced to buy. That reduces the Fed's capital, giving them less to lend. As a result, they can charge higher interest rates. That slows economic growth and mops up inflation. 

Fed Funds Rate (FFR)

The fed 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

The Fed also changes the discount rate. That's the interest rate the Fed charges to allow banks to borrow funds from the Fed's discount 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 Chairman Ben Bernanke noted that public expectations of inflation are an important influencer of the inflation rate. Once people anticipate future price increases, they create a self-fulfilling prophecy. They plan for future price increases by buying more now, thus driving up inflation even more.

On Nov. 3, 2021, the FOMC announced that it would allow a target inflation rate of more than 2% if that would help ensure maximum employment. It still seeks a 2% inflation over time but is willing to allow higher rates to balance out historical lower rates so that the average is still above 2%.

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. That volatility convinced 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. 

The past fed funds fate tells you how the Fed managed the expectations of inflation.

The next chairman, Alan Greenspan, followed Volcker's example. During the 2001 recession, the Fed lowered interest rates to end the recession. By mid-2004, it slowly but deliberately raised rates to avoid inflation.

How Well the Fed Is Controlling Inflation Now

After the 2008 financial crisis, the Fed 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 would create inflation once the global economy recovered. But the Fed created an exit plan to wind down the innovative programs, and ended quantitative easing and its purchases of Treasurys.

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, in October, inflation rose to a startling 6.2% year-on-year, a level not seen since 1990.

By March 2022, inflation had soared to 8.5%, prompting the Fed to raise interest rates for the first time since 2018. The Fed increased interest rates again at the May 2022 FOMC meeting, this time by half a percentage point (50 basis points). The target fed funds rate was increased to between 0.75% and 1.00% on May 4, 2022.

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.

Article Sources

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