"We've had one inflation fighting, yes, but what about second inflation fighting?" - Pippin

"I don't think he knows about second inflation fighting, Pip." - Merry

How does the Fed help fight inflation?

If you’ve been paying any attention to economic news in the last 3 years, you’ve likely heard something about the Fed and inflation. You’ve heard about the “rate” going up or inflation being too high or unemployment being above target. All these things are linked to what the Fed does to help with inflation. The elephant in the room is always: How does the Fed help with inflation? In other words, what is it that they do to affect inflation? How is it all linked? If you’ve ever wondered how this works, you’re in the right place!

This isn’t an article about the history of the Federal Reserve. However, I will say that the Federal Reserve(the “Fed”) is the central bank of the United States. It exists because of the financial panic in the early 1900s and the creation of the Federal Reserve Act of 1913. Basically, the Fed was created to help stabilize the banking system in the US. That’s all I’ll say on that part.

How does the Federal Reserve help with inflation? The Fed has several tools at its disposal to help us with inflation. These tools include: the Federal Funds Rate, the Discount Rate, Open Market Operations, and the Reserve Requirement.

The Federal Funds Rate is what people are referring to when they say the “rate” or the “fed rate.” This is the rate that banks charge each other to borrow money overnight. It is expressed as a range. For example, as of today’s writing, the rate is 5.25%-5.50%. I wrote extensively on this page about how this affects the “Prime Rate,” so check it out if you’re curious.

You may be thinking, “Wait a minute. Banks borrow money from other banks?” Yes, they do. This happens all the time. I’ve experienced this firsthand while working at a bank where the commercial loan production outpaced the amount of deposits on-hand at the bank, so the bank borrowed money to fund the new loans and simultaneously ran a deposit campaign aimed at bringing in more dollars by offering a higher interest rate than the competition.

Changing the Federal Funds Rate has a trickle-down effect on all borrowing. Here’s how it works: if banks pay a higher interest rate to borrow money, they pass those costs to the customer by raising the “Prime Rate.” Banks don’t eat those costs—they are passed to you. If the prime rate goes up, that means the rate on all loans across the US goes up as well(including HELOCs, auto loans, credit cards, etc.). For many people who are thinking about borrowing money, they may decide to hold off if the rates increase. Therefore, overall borrowing goes down. What is the result? Less home purchases, less auto loans, less home improvement purchases, less economy-boosting activities. What is the result of less purchases in all these industries? The “economy” slows down. When the economy slows down, so does the inflation rate. Conversely, if the economic growth rate is high, inflation will be high. Think about what happened recently after everyone got their rounds of government refund checks related to COVID. People were buying like crazy and the economy was booming. Suddenly, inflation shot up. That is going to be the result every time. So, one way to slow down inflation is to slow down the economy. Increasing the interest rate on loans slows down the economy because less people borrow money and that results in less purchases being made.

The Discount Rate is the next tool available to the Fed. This is the rate that the Fed charges banks to borrow money from the Fed(Central Bank) itself. The effects of this are similar to the Federal Funds Rate mentioned above. Basically, if it costs banks less to borrow money to operate, they may borrow more than the bare minimum and try to make more money from what they borrow. One reason banks might borrow money from the Fed is to satisfy the Reserve Requirement, which I’ll talk about shortly.

If you picture a business needing to borrow money from a bank, and the reasons it may need to do so, simply switch the names around to get an idea of the discount window: replace “business” in the previous sentence with “bank” and replace “bank” with “the Fed.” Now you may get a better idea of why the bank may need to borrow money from the Fed.

Open Market Operations is something you have probably heard a lot about without even realizing it. Whenever you hear about the Fed buying or selling securities, this is what it means. Officially, those actions are known as open market operations, or OMO. If the Fed wants rates to come down, it will buy securities, also known as expansionary monetary policy. This increases the cash supply for banks to lend more money. Having more money available to lend results in lower rates(think supply and demand). This is meant to stimulate growth. If the Fed wants rates to rise, they sell securities to banks. Since banks are using their money to buy securities, resulting in less cash on-hand for them, it leads to rates going up. Again, supply and demand kicks in because if there is less money available then it will cost more to borrow it. I’ll add that the rates I’m discussing here are only the rates that banks charge customers. I’m not talking about the Fed rate or Discount rate in this paragraph. If the Fed wanted one of those two rates to change, they simply must hold a meeting and vote to change it. Money supply is another tool at their disposal.

Historically, the Fed has required banks to keep a Reserve Requirement on hand. This means that the banks can’t lend 100% of their money to customers. Banks would prefer to lend all their money because that’s their number one way for them to earn income. The idea behind the reserve requirement is that if a “run” happened on the bank, they’d still have at least a guaranteed minimum amount of cash available. For years, the reserve requirement was 10%. That means if the bank had $100,000 in deposits, they could lend out $90,000 of it and keep $10,000 in cash. They were not allowed to lend that remaining $10,000 reserve. In March 2020, the Fed eliminated the reserve requirement. The idea was to get more money out into society instead of keeping it inside vaults at banks. In reality, this would be more than $10,000 per bank—it would be well into the billions of dollars range across the board. The intention was to kickstart the economy. Conversely, if the Fed sudden reinstituted the reserve requirement of 10%, billions of dollars would leave the money supply and go to the Fed. This would slow the economy down.

I hope this helps clear up the four different tools that the Fed can use to fight inflation. These are all things we hear about regularly on the news, but perhaps they didn’t make any sense. After all, news anchors and correspondents discuss them like everyone already knows what they mean. If you just read this article, then you are likely a part of the majority of people who hear a foreign language when hearing about this stuff. Hopefully, you have an idea of what they’re talking about now.