How does the Central bank control inflation?

You may have heard in the news in the last year, that the Fed has been raising the interest rate. In this post, I will be explaining which is the “interest rate” and how the central bank of the U.S. (the Federal Reserve) does that to control inflation.

After Jan 2022, there has been a steady rise in prices of many items, esp. fuel, housing rent, and food prices. If you want to understand what inflation is and how it is calculated, you can read my detailed article on inflation here.

Inflation always happens when there is more demand than supply and when there is an expectation of inflation to continue. Producers raise the price of the goods and services in demand, to make more profit from them.

The central bank of a country (the Federal Reserve in the US) intervenes when inflation is out of control or is significantly high compared to the target level. As this blog mostly focuses on the US Federal Reserve monetary tools, I use the terms the Fed and central bank interchangeably. However, central banks in other countries also use similar monetary tools.

Is inflation always bad?

In the US and many advanced countries, the target average rate of inflation is around 2% every year. This little bit of inflation rate is considered desirable, as it helps borrowers pay off their debt. When there is some inflation, borrowers will have to pay slightly less in purchasing power terms because their money is now worth less to the lenders, exactly by the rate of inflation.

Additionally, it also motivates people to spend their money on goods and services instead of holding on to them, as their money will lose its value next year by the rate of inflation. So, we get our normal production and consumption, and the economy continues to run smoothly.

What are the two goals of a central bank and how does it achieve it?

The central bank uses monetary policy to keep inflation low and promote maximum employment. By maximum employment, we mean the highest level of employment that an economy can sustain while maintaining a stable inflation rate. In the US, these goals are referred to as the Fed’s dual mandate.

You may ask how the Fed achieves its dual goals. Essentially, the Fed uses its monetary policy tools to start a chain reaction in the economy, each causing one another. In the US, the Fed’s chief body for monetary policymaking is called the Federal Open Market Commission (FOMC). FOMC meets eight times a year and looks at data on current economic conditions, like what is going up and what is going down and how the economy is likely to do in the future based on the data. Based on that information the FOMC makes monetary policy decisions.

When inflation is high for a long period and unemployment is at a very low level, we call it an overheating economy. The central banks try to raise the interest rates to slow down the overheating economy. This is called contractionary or tight monetary policy.

Tools of Monetary Policy

Now, let’s look at the tools the Fed can use to bring inflation down to the stable 2% average rate. This is done in two steps:

First, the Federal Open Market Committee (FOMC) will raise the target range for the Federal funds rate. This is the rate at which commercial banks borrow and lend their excess reserves to each other overnight. This rate is not set by the Fed, instead, it is determined by the market forces of demand and supply between commercial banks.

On any given date, there are many different transactions in the federal funds market and they settle at slightly different rates, the effective federal funds rate measures the median rate of these transactions.

FOMC sets a target range for the federal funds rate. In other words, the majority of the banks’ transactions should fall within the target range. Banks with deficits can borrow money from other commercial banks. The next day those banks return the money with a little bit of interest.

Now, the main task for the Fed is to use its monetary tools so that this federal funds rate goes up because this is the driving force for all the other interest rates in an economy.

Interest on reserve balance is the main tool

So, to steer the federal funds rate in the target range set by FOMC, the Fed uses interest on reserve balance as its primary monetary policy tool. The interest on reserve balances rate is the interest received by commercial banks on deposits that banks hold in their reserve balance account at a regional Federal Reserve Bank. This interest rate is a risk-free investment option for commercial banks. This, the interest on reserve balances rate is set by the Fed and is, therefore, an “administered rate,”.

Interest on reserve balance: Banks can deposit the excess reserve with the Fed risk-free overnight, and earn interest just like you can do with a savings account.

When the Fed sees the economy is overheating with high inflation and a tight labor market, it tries to slow down the economy by raising the interest on the reserve balance. With that, the banks will be more willing to deposit their reserves with the Fed, rather than lending to other banks in the federal funds market.

A key point to note here is that the interest on reserve balances rate serves as a reservation rate or the floor rate for banks. This is the minimum interest banks would be willing to accept in order to lend to each other, rather than keeping it with the Fed. If the Fed raises this interest on the reserve balance, commercial banks must raise the Federal funds rate in order to attract other banks to lend to them.

Another key concept that ensures that the federal funds rate does not fall far below the interest on reserve balances rate is called arbitrage. Arbitrage means simultaneous purchase and sale of funds (or goods) in order to profit from a difference in price.

So, for example, if we assume the federal funds rate is 1.75 percent and the interest on reserve balances rate is slightly higher at 2.25 percent, banks will see that they can borrow funds in the federal funds market at a lower rate and earn higher interest by depositing those funds at the Fed. They will keep doing that until with the forces of demand and supply, the increase in demand for funds in the federal funds market will cause the federal funds rate to rise. It will keep rising until it reaches the interest on reserve balances rate so that banks no longer see the opportunity to profit by borrowing in the federal funds market and depositing it with the Fed. 

As the Fed sets the interest on reserve balances rate directly, the Fed can steer the federal funds rate up or down by raising or lowering the level of the interest on reserve balances rate. In fact, this phenomenon of arbitrage makes interest on reserve balances a very effective tool for steering the federal funds rate direction.

There are two other tools that the Fed can use to guide the federal funds rate

1. By setting a floor with an overnight reverse repurchase rate,

2. and by setting the ceiling using a discount window

Let’s understand both of them.

The Fed has an overnight reverse repurchase facility that is open to a broader set of financial institutions, as interest on reserve balances is available only to banks and a few other institutions. This facility allows these financial institutions to deposit their funds at a Federal Reserve Bank and earn the overnight reverse repurchase agreement rate offered by the Fed.

Thus, the overnight reverse repurchase agreement rate does the same thing as the interest on reserve balances rate does by acting as a reservation rate for these financial institutions. If this rate is higher than the federal funds rate, then by pressure of demand and supply, the Federal funds rate starts going up until there is no profit from arbitrage. The overnight reverse repurchase agreement facility is a supplementary tool because the rate the Fed sets for it helps set a floor for the federal funds rate.

So when it raises the overnight reverse repurchase rate, the Federal funds rate tends to move up as well.

The discount rate is the rate banks have to pay to the Fed for borrowing money from the Fed through the Fed’s discount window. Banks are more likely to borrow from each other (at the federal funds rate) only if it is lower or equal to the discount rate that they have to pay to borrow from the Fed. Thus, the discount rate acts as a ceiling for the federal funds rate. Also, it is set higher than the interest on reserve balances rate and the overnight reverse repurchase agreement rate.

Lastly, there is another tool that used to be the Fed’s primary tool to control the money supply in the economy before the 2008 financial crisis. This is called open market operations where the Fed would buy or sell t-bonds. Now, with ample reserves in the banking system, the Fed only uses this as a supplemental tool to help maintain ample levels of reserves. The Fed can buy or sell government securities in the open market to increase or decrease these reserves in the banks account with the Fed.

In a nutshell, when the Fed wants to control inflation, it would set a higher range for the Federal funds rate. To achieve this target, it would increase the interest on reserve balances rate as the main monetary policy tool. It can also use additional tools by raising overnight reverse repurchase agreement rate, and discount rate. All this will ensure the federal funds rate stays within the high target range set by the FOMC.

Why does the Federal fund rate matter?

Since the federal funds rate affects all the other interest rates in the economy, all the other interest rates go up as well. At high interest rates, households will borrow less money to buy big-ticket items they want. This will cause a reduction in spending by households. This will cause overall savings to increase because now they are getting higher interest rate to save money in a bank.

Once household demand is reduced, firms will reduce their investments. They will also reduce their workforce and demand fewer workers. This will reduce employment levels also and cause the inflated prices to return to the target of 2%.

The now-raised federal fund rate would cause other market interest rates like mortgage, auto, and other interest rates that banks charge from households and businesses to rise as well. The increased cost of borrowing will reduce spending across all sectors of the economy, lowering excess demand and bringing prices back to normal.

The Fed will do the exact reverse of this process when the economy is in a recession when the inflation is below the 2% target rate and there is high unemployment. It will lower the Federal funds rate target range by lowering interest on the reserve balance. It can also use additional help from lowering interest on overnight reverse repurchase agreement rates, and discount rates to give a boost to the economy.

How effective are these tools in reality?

All these monetary policy tools only work when inflation is caused by demand-pull factors. However, if it is due to cost-push factors, this measure may cause more harm than good. Cost-push factors include supply shocks when the supply of the products is hampered. There could be many reasons for a reduction in supply such as increased cost of raw material and other inputs, and natural calamities. Trade restrictions such as sanctions imposed on a country can also cause supply disruptions.

Also, there is a direct link between reducing inflation and reducing overall economic growth. Even though central banks aim for a soft landing when they raise interest rates to bring down inflation, sometimes it doesn’t go as planned.

In economics, a soft landing means a moderate economic slowdown following a period of growth. In the past, the Fed in the US has had a mixed record in achieving a soft landing when it raised interest rates.

In addition, inflation expectations continue to play a key role in how people react to the contractionary monetary policy. If people continue to believe the prices to go up, they will tend to make the purchases now, rather than in the future when the worth of their money can get further low.

The board of governors at the Fed, as well as various economists that work there, take into consideration all these factors and keep a watch on the trend. They can alter the monetary policy according to the direction of its performance.