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 Fed's ideal inflation rate is around 2%—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 tame inflation. It usually uses open market operations (OMO), the fed 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 prices increases by buying more now, thus driving up inflation even more.

On Nov. 3, 2021, 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.

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 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.