Inflation occurs when spending on goods and services exceeds output. Prices may increase because of supply constraints that drive up the cost of producing goods and rendering services, or because consumers are spending more money than producers can generate as a result of a developing economy. Inflation is typically caused by the combination of these two circumstances.
Governments usually strive to keep inflation at a reasonable range that promotes growth without drastically reducing the value of the currency. Most of the responsibility for controlling inflation in the United States rests with the Federal Open Market Group (FOMC), a committee of the Federal Reserve that decides on monetary policy to accomplish the Fed’s goals of stable prices and maximum employment.
There is no foolproof technique to curb inflation, although some methods have shown to be more effective and result in less collateral damage than others.
Governmental price floors or caps are set on specific items to control prices. To lessen wage drive inflation, price controls can be used in conjunction with pay controls.
To address rising inflation, American President Richard Nixon issued a number of stringent price controls in 1971. Price restrictions were initially favored and believed to be effective, but they fell short in 1973 when inflation rose to its worst levels since World War II.
Even in the face of a number of intervening factors, such as the end of the Bretton Woods System, below-average harvests, the Arab oil embargo, and the complexity of the price control system at the time, the majority of economists believe that the 1970s provide sufficient evidence that price controls are an ineffective tool for controlling inflation.
Contraction in Monetary Policy
Today, more people adopt contractionary monetary policy to fight inflation. A contractionary policy aims to lower the amount of money in an economy through increasing interest rates.
As a result, credit becomes more expensive, which reduces consumer and business spending and slows economic growth.
Higher interest rates on government securities also impede growth by incentivizing banks and investors to buy Treasuries, which offer a fixed rate of return, rather than the riskier equity investments, which profit from low interest rates. Here are several strategies the Federal Reserve, the nation’s central bank, use to fight inflation.
Rate of Government Funds
The federal funds rate is the price at which banks lend money to one another overnight. The fed funds rate is not directly managed by the Federal Reserve. Instead, to bring interbank rates into the target range for the fed funds rate, the FOMC adjusts the interest on reserves (IOR) and overnight reverse repurchase agreement (ON RRP) rate.
IOR is the interest rate that banks get on their deposits with the Federal Reserve. IOR is the lowest interest rate that a responsible lender should accept because it is viewed as a risk-free rate because the United States has never had a default on a debt.
The ON RRP rate operates similarly. It exists because not every financial institution keeps deposits with the Federal Reserve. Under the ON RRP, these institutions are allowed to essentially purchase a federal security at night and resell it to the Fed the following day. The ON RRP rate is the difference between the price at which a security is bought and sold.
By raising these rates, the Federal Reserve encourages banks and other lenders to raise interest rates on riskier loans and transfer more of their funds to the Federal Reserve, which is a no-risk institution, so reducing the amount of money in circulation and bringing inflation down.
Public Market Exchanges
Reverse repurchase agreements are a part of open market operations (OMOs), also referred to as the buying and selling of Treasury securities. OMOs are a tool used by the Federal Reserve to change interest rates and increase or decrease the money supply by buying or selling Treasury securities.
The Federal Reserve’s balance sheet grows as it buys securities, while it contracts when it sells them. Purchasing securities increases both, whereas selling assets has the reverse effect on interest rates and market liquidity.
Conditions for Reserve
Reserve requirements, or the amount of money banks had to hold on hand to satisfy withdrawals, were another way the Federal Reserve managed the money supply up until March 26, 2020. Banks had to hold aside more money the less they could lend to consumers.
Reserve requirements were abolished in March 2020, although the Fed has the authority to reinstate them in the future.
The discount rate refers to the interest rate that the Federal Reserve charges on loans given to commercial banks and other financial organizations. The lending mechanism utilized to make these quick loans is known as the discount window. The discount rate, which is the same for all Reserve Banks, is agreed upon by the Board of Governors of the Fed and the Board of Directors of each regional bank.
Although the discount window’s primary objectives are to satisfy banks’ short-term liquidity needs and maintain system stability, the discount rate is another interest rate that must be raised in order to control inflation.
Governments have few options for effective inflation control. They can impose a price cap, but it is debatable whether the extensive price controls required to reduce inflation will be effective. Contractionary monetary policy is the preferred course of action for lowering inflation right now, however achieving so-called “soft landings” is difficult.