What Will be the Fed Reaction to Rising Inflation?
As the prices of goods and services in the economy rise from high demand, and as input costs follow in tandem with supply chain shortages and commodity prices rising, the risk of rising inflation is high. This is a big worry for the US central bank, called the Federal Reserve. The Federal Reserve, also known as the “Fed” is in charge of regulating the financial system, including setting short term interest rates and regulating banks and financial institutions. The Fed mandates that it works to meet are; keeping inflation low at an average of 2% and working towards maximum employment in the economy. With inflation on the rise, the Fed will need to react and use its tools to try and prevent this from getting out of hand and to continue meeting its mandate of low and predictable inflation.
For the meantime, the Fed has stated they will let short term inflation be above their target inflation rate of 2%. This is in order to keep rates low to let the economy recover as strongly as possible to give people a chance to find jobs. This won’t be a long term solution to inflation however, especially if we see significant inflation above 3 or 4%. Three ways the Fed may react if inflation rises meaningfully above the target rate or persist longer term are:
1. Managing Expectations for Inflation
– Since the Fed is so powerful and relied upon within the financial system and as a forecasting body, what they say will lead to reactions from businesses and the public. This means the Fed will continue to downplay inflation when they speak in press conferences and make statements. If the Fed were to say they see high inflation in the present or future, it would lead to businesses and people going out and spending more in the present to get ahead of this inflation. This however would only lead to more inflation in the present time as demand increases and supply can’t keep up.
2. Slowing down Quantitative Easing (QE)
– Currently, the Fed has a program nicknamed QE, where they increase the supply of money by creating reserves. These reserves are funds which the Fed then uses to buy bonds with, primarily long-term government ones. This program leads to the money supply in the financial system rising, and leads to interest rates on bonds falling. The Fed doesn’t directly control interest rates aside from the overnight rate, and instead markets dictate short and long term interest rates through the prices on government treasury bonds. QE helps to especially bring these long term interest rates down with the added demand of the Fed purchasing these bonds. This is especially noteworthy because the interest rate on long term government bonds act as the foundation for the interest rate everyday people and businesses get for loans.
As the Fed looks to slow down inflation, they will use interest rates as their means to do this. By slowing down and stopping QE completely, this will naturally lead to interest rates, especially longer term ones starting to rise. This is because of the Fed no longer purchasing government bonds in order to bring interest rates down. Even if the Fed were to just announce they will be slowing down and stopping QE, the interest rates on government bonds would rise. This would also cause the interest rates on bonds throughout the bond market to rise as well.
3. Raise the Fed Funds Rate
– The Fed Funds rate is the target interest rate that commercial banks lend to each other at. This is important because banks need to maintain certain levels of reserves (money) in order to meet regulatory requirements set out by the Fed. By raising the Fed Funds target interest rate, this will lead to borrowing costs rising for commercial banks, which they will then pass along to the businesses and consumers who need loans. This will not only affect short term interest rates such as prime rates at commercial banks, but will also affect longer term interest rates. If the Fed Fund Rate rises, this will lead to the expectation of higher interest rates in the future, which will lead to higher long term interest rates as a result.
Overall, the last two options are aimed at raising the cost of borrowing, both for short term interest rates and for long term interest rates. The idea is that higher borrowing costs for consumers and businesses will lead to lower demand for goods, services, and investments. Although a ripple effect of this is the economy slowing, it does however lead to prices moderating and inflation concerns subsiding.
