How Do Governments Fight Inflation?

Inflation occurs when spending on goods and services outstrips their 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, are spending their excess cash faster than producers can increase production. Inflation is often caused by some combination of these two factors.

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 body that regularly revises the government's monetary policy to achieve the Fed's goals of stable prices and maximum employment.

Price Controls

Price controls are price caps or floors mandated by a 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 a 90-day freeze on wages and prices in an attempt to counteract rising inflation. This was initially popular and considered effective but it could not control prices when, in 1973, inflation skyrocketed to its highest levels since World War II.

Despite some intervening factors—such as the end of the Bretton Woods System, poor harvests, an 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

Contractionary monetary policy is nowadays considered a more effective means 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 to obtain, 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 overnight lending system is a vast flow of cash among financial institutions that allows banks to use their excess cash profitably or maintain the adequate cash reserves they need to do their day-to-day business.

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.

Interest on reserves is 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 would require.

The overnight RRP rate has a similar function for financial institutions that do not 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 their riskier loans and siphon more of their money to the no-risk Federal Reserve. The effect is a reduction in the money supply, which has the effect of reducing inflation.

Open Market Operations

Reverse repurchase agreements are an example of open market operations (OMO), which refers to the buying and selling of Treasury securities. OMOs are a tool that the Federal Reserve uses to increase (by buying Treasuries) or decrease (by selling Treasuries) the money supply.

The Federal Reserve balance sheet, the weekly financial report that indicates what the Fed owns and what it owes, grows when the Fed buys securities and shrinks when it sells them. Buying securities promotes liquidity in the financial markets and puts downward pressure on interest rates. 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 have been set at zero since that date, the Fed retains the authority to restore them 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.

The discount window's primary purpose is to fulfill banks' short-term liquidity needs and maintain stability in the banking system. However, the discount rate is yet another interest rate that can be raised to temper inflation.

The Bottom Line

In modern times, the preferred method of controlling inflation is through contractionary monetary policies imposed by the nation's central bank. The alternative is a cap on prices, which don't have a great record of success.

In either case, soft landings are hard to pull off. Anti-inflationary measures have to be aggressive enough to slow the economy down while not tipping it over into recession.