Inflation occurs 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. In the U.S., much of the responsibility for controlling inflation 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.
- Governments can use wage and price controls to fight inflation, but these policies have faired poorly in the past.
- Governments can also 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.
How Can the Government Control 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 a number of 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.
Contractionary Monetary Policy
Today, contractionary monetary policy is a more popular method of controlling inflation. The goal of a contractionary policy is 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, the Federal 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 (IOR) and the overnight reverse repurchase agreement (ON RRP) rate—to push interbank rates into the ideal fed funds range.
IOR is the rate banks earn on their deposits with the Federal Reserve. Since the U.S. has never defaulted on its debt, IOR is considered a risk-free rate and, thus, the lowest interest rate any reasonable lender should accept.
The ON RRP rate functions similarly. It exists because not all financial institutions have deposits with the Federal Reserve. The ON 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.
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.
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.
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.