How the Federal Reserve Controls Inflation

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 ideal economic growth rate is between 2%-3%. If it's higher than that, demand will drive up prices for too few 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 becomes more expensive to get loans. It slows economic growth and demand, which puts downward pressure on prices.

Tools the Federal Reserve Uses to Control Inflation

The Fed has several tools it traditionally uses to implement contractionary monetary policy. It only does this if it suspects inflation is getting out of hand. It usually uses open market operations, the fed funds rate, and the discount rate in tandem. It rarely changes the reserve requirement.

Open Market Operations

The Fed's first line of defense is open market operations. 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 their 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

The fed funds rate is the most well-known of the Fed's tools. It's also part of its open market operations. It’s 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 much 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 said the Fed's most important tool is managing public expectations of inflation. Once people anticipate future price increases, they create a self-fulfilling prophecy. They plan for future prices increases by buying more now, thus driving up inflation even more.

On August 27, 2020, the FOMC announced it would allow a target inflation rate of more than 2% if that will help ensure maximum employment. It still seeks a 2% inflation over time but is willing to allow higher rates if inflation has been low for a while.

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.

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 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.

Greenspan told investors exactly what he planned to do, thus avoiding another recession. He reassured market investors, who kept investing and spending despite higher interest rates.

How Well the Fed Is Controlling Inflation Now

Since the 2008 financial crisis, inflation hasn't been much of a concern. Instead, the Fed focused on preventing another recession. During the crisis, the Fed created many innovative programs. It quickly pumped trillions of dollar 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. It ended quantitative easing and its purchases of Treasurys.

The Fed encourages a moderate inflation rate with inflation rate targeting. The target is 2% for the core inflation rate. That's the measurement of inflation excluding gas and food prices, which can be very volatile.

When people expect prices to rise, they buy more now to avoid future price increases. That generates the demand needed for a healthy economy.

Inflation rate targeting also means that the Fed won't allow inflation to rise much above the target. If inflation rises too much above the target, the Fed will implement contractionary monetary policy to keep it from spiraling out of control.