How does FED control Inflation and what techniques do they use?
WavyTrades LLC
10 July 2023.
How the FEDs Control Inflation?
Experiencing inflation is a common economic phenomenon that occurs when the general level of prices for goods and services rises over time. It means that each unit of currency (e.g., dollar, euro, etc.) buys fewer goods and services compared to the past. Inflation is measured as an annual percentage increase in the price level. It’s important to note that moderate inflation can be considered healthy for an economy as it encourages spending and investment. Central banks often aim to maintain a low and stable level of inflation, usually around 2% annually, as part of their monetary policy to support economic growth and stability. However, high and uncontrolled inflation can lead to significant economic challenges, such as reduced purchasing power, uncertainty, and distortions in financial decision-making. The methods and techniques used by central banks like the Federal Reserve (FED) to fight inflation are fairly standard. However, we need to keep in mind that the economic landscape changes over time, and new strategies may be implemented.
A few of the common techniques used by the FED to combat inflation are:
Monetary Policy: The primary tool used by the Federal Reserve to control inflation is Monetary Policy. The FED can adjust the money supply and interest rates to influence economic activity. To fight inflation, the FED typically implements a contractionary monetary policy. This involves reducing the money supply while increasing interest rates which has been the course of action over the last 12+ months. This includes:
Open Market Operations: The FED buys and sells government securities in the open market to control the money supply. In order to fight inflation, they sell government securities to reduce the money supply and take money out of circulation.
Discount Rate: The discount rate is the interest rate at which commercial banks can borrow funds directly from the Federal Reserve. If the FED raises the discount rate, it becomes more expensive for banks to borrow, leading to reduced lending and money creation.
Reserve Requirements: In this process, the FED adjusts the percentage of deposits that banks are required to keep as reserves. Raising reserve requirements reduces the amount of money banks can lend, putting downward pressure on inflation.
Forward Guidance: The FED provides forward guidance on its intended future monetary policy actions. By indicating its stance on future interest rate adjustments, it can influence long-term borrowing costs and consumer expectations, affecting spending and investment decisions.
Sterilization: If the FED wants to intervene in the foreign exchange market to manage inflation, it can engage in sterilization operations. This means offsetting the impact of its foreign exchange interventions on the domestic money supply to prevent inflationary pressures.
Jawboning: This is a communication strategy where FED officials use speeches and statements to influence market expectations. By clearly expressing their commitment to fighting inflation, they aim to shape the behavior of businesses and consumers.
Inflation Targeting: The FED, like many other central banks, may use inflation targeting as a framework for conducting monetary policy. They set a specific target for the rate of inflation and adjust their policy measures to achieve that target.
Fiscal Policy Coordination: While fiscal policy is under the domain of the government and not the central bank, cooperation between the FED and the government can help manage inflation. Coordinated fiscal and monetary policies can be more effective in controlling inflationary pressures.
It’s important to note that the effectiveness of these techniques depends on the prevailing economic conditions, the degree of inflationary pressure, and many other external factors. Also, central banks need to strike a balance between controlling inflation and promoting economic growth to maintain a stable and healthy economy.
