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. If the gross domestic product growth rate is more than the ideal of 2-3 percent, excess demand can generate inflation by driving up prices for too few goods.

The Fed can slow this growth by tightening the money supply, which is 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.

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. Its 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.

Second, the Fed can raise the reserve requirement. That's the amount banks must keep in reserve at the end of each day. Increasing this reserve keeps money out of circulation.

Third, the Fed can raise the discount rate. That's the interest rate the Fed charges to allow banks to borrow funds from the Fed's discount window.

The Fed rarely modifies these two tools. Instead, it usually changes the fed funds rate. It's the interest rate banks charge for loans they make to each other to maintain the Reserve requirement. That's much easier for the Fed to modify. It has the same effect as changing the Reserve requirement and discount rate.

Former Chairman Ben Bernanke said the Fed's most important tool is managing public expectations. Once people anticipate inflation, they create a self-fulfilling prophecy. They plan for future prices increases by buying more now, thus driving up inflation even more.

Bernanke said the mistake the Fed made in controlling inflation in the 1970s was its stop-go 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. The past fed funds fate tells you how the Fed managed the expectations of inflation.

Since the 2008 financial crisis, the Fed focused on preventing another recession. During the crisis, the Fed created many innovative programs. They quickly pumped trillions of dollar of liquidity to keep banks solvent. Many were worried that this would create inflation once the global economy recovered.

The Fed created an exit plan to wind down the innovative programs. It ended quantitative easing and its purchases of Treasurys. That program created asset inflation in stocks in 2013, bonds in 2012, and gold in 2011. But it affected investors, not consumers.

The Fed encourages a moderate inflation rate with inflation rate targeting. The target is 2 percent for the core inflation rate. That's the measurement of inflation excluding gas and food prices, which can be very volatile. A little bit of inflation can encourage growth. That's because people expect prices to rise, so 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 2 percent core inflation rate. If inflation rises too much above the target, the Fed will implement contractionary monetary policy to keep it from spiraling out of control. To find out how well the Fed is controlling inflation, The current inflation rate tells you how well the Fed is controlling inflation.