How the Fed Manages Prices Using Its Instruments
The Federal Reserve’s main responsibility is to keep inflation under control while averting a recession. It accomplishes this through monetary policy. The Fed must adopt a contractionary monetary policy to impede economic growth in order to control inflation. If inflation rises above the Fed’s target level of 2%, demand will increase prices for goods.
By reducing the amount of available money, the Fed can reduce this increase. It is the total credit allowed to enter the market. The financial system’s liquidity is decreased as a result of the Fed’s policies, raising the cost of borrowing money. It lowers demand and economic expansion, which drives down prices.
Main Points
The Fed’s long-term annual target inflation rate is 2%.
Monetary instruments can reduce or increase the money supply.
These instruments consist of the discount rate, open market operations, and the federal funds rate.
Another key tactic is controlling people’s expectations of inflation.
The Federal Reserve’s Instruments for Controlling Inflation
The Fed employs a number of techniques to control inflation. Open market operations (OMO), the federal funds rate, and the discount rate are frequently combined. Infrequently does it alter the reserve need.
Public Market Transactions (OMO)
OMO is the first line of defense for the Fed. Through its member banks, the Fed purchases or sells securities, primarily Treasury notes. When it wishes to have more money to lend, it purchases securities. These securities, which the banks are compelled to purchase, are sold by it. As a result, the Fed has less capital available to lend. They are able to charge greater interest rates as a result. That curbs inflation while slowing economic development.
Federal Funds Rate (FFR)
The Fed’s main instrument is the fed funds rate (FFR), which is the most well-known. It also comprises its OMO. The FFR is the interest rate that banks charge one another for overnight lending. It is simpler for the Fed to adjust and has the same result as changing the Reserve requirement.
Amount Offered
The discount rate is also adjusted by the Fed. It is the interest rate the Fed levies on bank loans made through its discount window.
Need for Reserves
The amount that banks had to hold in reserve at the end of each day was known as the reserve requirement. The reserve was increased, keeping money out of circulation.
the Reserve Requirement and Fed fund rate are both affected by changes. With effect from March 26, 2020, the Fed abolished the reserve requirement.
the control of public expectations
The public’s expectations of inflation, according to former chairman Ben Bernanke, are a significant factor in the inflation rate. Those who predict price rises in the future start a self-fulfilling prophecy. By making larger purchases today, they anticipate price hikes in the future, thus increasing inflation.
You may learn from the Fed’s past responses to inflation about what could work and what might not. According to Bernanke, the Fed’s go-stop monetary strategy was the mistake it made in the 1970s when trying to manage inflation. It first increased rates to fight inflation before lowering them to prevent a recession. The uncertainty persuaded enterprises to maintain high prices.
The Fed’s Reaction to Inflation Throughout History
Paul Volcker, chairman of the Fed, hiked rates to tame the unpredictability. Despite the 1981 recession, he maintained them there. Everyone realized prices had stopped rising, and that helped to contain inflation.
Note
You may learn how the Fed handled inflation expectations by looking at past Fed Funds performance.
Alan Greenspan, the following chairman, adopted Volcker’s strategy. The Fed cut interest rates in 2001 to put an end to the recession. To prevent inflation, it gradually but purposefully hiked rates by the middle of 2004.
After the 2008 financial crisis, the Fed concentrated on averting another recession. The Fed came up with a lot of creative projects throughout the crisis. To keep banks solvent, it immediately pumped tens of billions of dollars of liquidity.
Many people were concerned that once the global economy recovered, this would lead to inflation. But, the Fed stopped its quantitative easing program and stopped buying Treasurys, creating an exit strategy to wind down the creative programs.
How effectively the Fed is now managing inflation
The Fed has to increase its quantitative easing during the 2020 pandemic and lower interest rates to stop the recession from starting quickly. Federal funds rates decreased to 0%–0.25%, which boosted the economy. The economy started to recover significantly by 2021. But as the year came to a close, inflation spiked to levels not seen since 1990.
The Federal Reserve started hiking rates in 2022 to combat inflation, and it intends to do so throughout the duration of the year.
Questions and Answers (FAQs)
How does inflation be stopped by rising interest rates?
Increasing interest rates makes borrowing more expensive, which lowers inflation by slowing the economy. Less people borrow money to establish businesses or buy homes when interest rates rise. Theoretically, prices will decrease when demand for homes, workers, and other goods and services declines.
Who oversees inflation in Japan, India, and other nations?
Similar to the Federal Reserve, several nations have central banks. To ensure price stability, these banks engage in monetary policy operations. For instance, the Reserve Bank of India serves as the nation’s main bank. The Bank of Japan is another option. The European Union’s monetary policy is overseen by the European Central Bank.