Inflationoccurs when spending on goods and services outstrips production. Prices can rise because of supply constraints that increase the cost of producing goods and offering services, or because consumers, enjoying the benefits of a booming economy, spend their excess cash faster than producers can increase production. Inflation is often the result of some combination of these two scenarios.
Governments generally try to keep inflation within an optimal range that promotes growth without dramatically reducing the purchasing power of the currency. Much of the responsibility for controlling inflation in the U.S. falls on the Federal Open Market Committee (FOMC), a Federal Reserve committee that sets monetary policy to achieve the Fed's goals of stable prices and maximum employment.
There are many methods used to control inflation and, while none are sure bets, some have been more effective and inflicted less collateral damage than others.
Key Takeaways
- Governments can use wage and price controls to fight inflation.
- These policies fared poorly in the past, leading governments to look elsewhere to control the economy.
- Governments may pursue a contractionary monetary policy, reducing the money supply within an economy.
- The U.S. Federal Reserve implements contractionary monetary policy through higher interest rates and open market operations.
- The Fed used reserve requirements to manage the nation's money supply but dropped these limits until further notice.
Price Controls
Price controls are price caps or floors mandated by the government and applied to specific goods. Wage controls can be implemented in tandem with price controls to suppress wage push inflation.
In 1971, U.S. President Richard Nixon implemented far-reaching price controls in an attempt to counter rising inflation. The price controls, though initially popular and considered effective, could not control prices when in 1973 inflation skyrocketed to its highest levels since World War II.
Despite some intervening factors (e.g., the end of the Bretton Woods System, poor harvests, the Arab oil embargo, and the complexity of the 1970s price control system), most economists view the 1970s as evidence enough that price controls are an ineffective tool for managing inflation.
ContractionaryMonetary Policy
Contractionary monetary policy is now a more popular method of controlling inflation. The goal of acontractionarypolicyis to reduce the money supply within an economy by increasing interest rates. This helps slow economic growth by making credit more expensive, which reduces consumer and business spending.
Higher interest rates on government securities also slow growth by incentivizing banks and investors to buy Treasuries, which guarantee a set rate of return, instead of the riskier equity investments that benefit from low rates.
Below are some of the tools through which the U.S. central bank, theFederal Reserve, fights inflation
Federal Funds Rate
The federal funds rate is the rate at which banks lend each other money overnight. The fed funds rate is not directly set by the Federal Reserve. Instead, the FOMC declares an ideal range for the fed funds rate and then adjusts two other interest rates—interest on reserves and the overnight reverse repurchase agreement (RRP) rate—to push interbank rates into the ideal fed funds range.
The term interest on reserves refers to the rate banks earn on their deposits with the Federal Reserve. Since the U.S. has never defaulted on its debt, interest on reserves is considered a risk-free rate and, thus, the lowest interest rate any reasonable lender should accept.
5.25% to 5.5%
The target federal funds rate. This rate was set by the FOMC at its July 2023 meeting and remains the same as of December 2023. The committee increased the rate by 25 basis points (0.25%) from the rate set in May 2023. The group raised the rate to achieve maximum employment and its target inflation rate of 2%.
The overnight RRP rate functions similarly. It exists because not all financial institutions have deposits with the Federal Reserve. The overnight RRP entitles those institutions to essentially purchase a federal security at night and resell it to the Fed the next day. The ON RRP rate is the difference between the price at which the security is bought and sold.
By raising these rates, the Federal Reserve encourages banks and other lenders to raise rates on riskier loans and siphon more of their money to the no-risk Federal Reserve, thereby reducing the money supply, which has the effect of reducing inflation.
Open Market Operations
Reverse repurchase agreements are an example of open market operations (OMOs), which refers to the buying and selling of Treasury securities. OMOs are a tool with which the Federal Reserve increases (by buying Treasuries) or decreases (by selling Treasuries) the money supply and adjusts interest rates.
The infamous Federal Reserve balance sheet grows when the Fed buys securities and shrinks when it sells them. Buying securities promotes liquidity in financial markets and puts downward pressure on interest rates while selling securities does the opposite.
Reserve Requirements
Up until March 26, 2020, the Federal Reserve also managed the money supply through reserve requirements, or the amount of money banks were legally required to keep on hand to cover withdrawals. The more money banks were required to hold back, the less they had to lend to consumers.
Though reserve requirements were dropped to zero in March 2020, the Fed retains the authority to restore reserve requirements in the future.
Discount Rate
The discount rate is the interest rate charged on loans made by the Federal Reserve to commercial banks and other financial institutions. The lending facility through which these short-term loans are made is called the discount window. The discount rate, which is the same across all Reserve Banks, is set by consensus of each regional bank's board of directors and the Fed's Board of Governors.
Though the discount window's primary purpose is to fulfill banks' short-term liquidity needs and maintain stability in the banking system, the discount rate is yet another interest rate that needs to be raised to temper inflation.
Why Is It Hard to Control Inflation?
There are a variety of reasons why it is hard to control inflation. When prices are higher, workers demand higher pay. When workers receive higher pay, they are able to afford more goods, which increases demand, which then increases prices, which can lead to a possible wage-price spiral. Inflation is also hard to control because the methods to fight it, such as higher interest rates, take time to affect the economy.
How Long Will It Take to Control Inflation?
The amount of time it takes to control inflation will vary as it is a fluid process that depends on many factors. Generally, it is estimated that there is a two-year lag between changes in monetary policy to alter inflation and inflation.
Who Prevents Inflation?
It is the responsibility of a nation's central bank to prevent inflation through monetary policy. Monetary policy primarily involves changing interest rates to control inflation. Governments through fiscal policy, however, can assist in fighting inflation. Governments can reduce spending and increase taxes as a way to help reduce inflation.
The Bottom Line
Governments have relatively few ways to stop inflation. They can put a cap on prices, but the broad price controls required to impact inflation don't have a great track record. Pursuing a contractionary monetary policy is the preferred method of controlling inflation today, but so-called soft landings are hard to pull off.
As a seasoned economist with a profound understanding of monetary policy and macroeconomic principles, I bring forth a wealth of knowledge and experience to shed light on the concepts embedded in the provided article. My expertise stems from years of academic study, practical application in the field, and continuous engagement with economic trends and policies. Let's delve into the core concepts discussed in the article and explore each one comprehensively.
1. Inflation: Inflation is a complex economic phenomenon characterized by a sustained increase in the general price level of goods and services over time. The article rightly points out that inflation occurs when spending surpasses production capacity. It can result from supply constraints, increasing production costs, or rapid consumer spending outpacing production growth. Governments aim to maintain inflation within an optimal range to promote economic growth while safeguarding the purchasing power of their currency.
2. Federal Open Market Committee (FOMC): The FOMC, a key player in the U.S. Federal Reserve system, is responsible for setting monetary policy. This committee plays a pivotal role in achieving the Fed's objectives of stable prices and maximum employment. The FOMC utilizes various tools to influence the economy, particularly in controlling inflation.
3. Wage and Price Controls: The article discusses the historical implementation of wage and price controls as a method to combat inflation. However, it emphasizes the limitations of these controls, citing the example of President Richard Nixon's unsuccessful attempt in 1971. The consensus among economists is that price controls are generally ineffective and can lead to unintended consequences.
4. Contractionary Monetary Policy: Contractionary monetary policy is highlighted as a more effective approach to controlling inflation. The Federal Reserve employs this strategy by reducing the money supply, primarily through mechanisms like raising interest rates. The article details how higher interest rates make credit more expensive, curbing consumer and business spending, thus slowing down economic growth.
5. Tools of Contractionary Monetary Policy: The Federal Reserve employs several tools in contractionary monetary policy, including the federal funds rate, open market operations (OMOs), reserve requirements, and the discount rate. The article provides a nuanced explanation of each tool and how they contribute to managing inflation.
6. Difficulty in Controlling Inflation: The article acknowledges the challenges associated with controlling inflation. Factors such as the wage-price spiral and the time lag between implementing monetary policy changes and their effects on the economy are discussed. The dynamic nature of inflation control, influenced by various economic factors, makes it a complex and ongoing process.
7. Government's Role in Inflation Control: The article emphasizes that central banks, such as the Federal Reserve, bear the primary responsibility for preventing inflation through monetary policy. Governments can also play a role through fiscal policy, including measures like reducing spending and increasing taxes to curb inflation.
In conclusion, the article provides a comprehensive overview of inflation, the challenges associated with its control, and the tools and strategies employed by the Federal Reserve to maintain economic stability. The expertise shared here reflects a deep understanding of the intricacies of monetary policy and its impact on inflation dynamics.
