Because interest rates, which are the main tool of the Federal Reserve to manage inflation, tend to move in the same direction, both inflation and interest rates will also be affected. Federal Reserve Act allows the Fed to encourage maximum employment and stable prices. The Federal Reserve has been aiming for an annual inflation rate of 2% since 2012 as part of its dual mandate to stabilize prices.
A positive inflation rate is defined by a steady rise in the price of goods and services. Deflation is a prolonged decline in prices. A positive rate of inflation and interest rates gives the central bank the ability to reduce rates to respond to economic slowdowns. This framework required Fed policymakers to maintain inflation above 2% for some time to compensate for periods when it fell below that target.
How Federal Reserve Measures Inflation
PCE Price Index is Federal Reserve's preferred inflation measurement. The PCE Price Index tracks consumer spending through business receipts, unlike CPI, which is based upon surveys of consumer purchase. The core PCE Price Index is also closely monitored by the Fed. It excludes volatile prices such as food and energy and is, therefore, less indicative of the overall trend in price.
How Interest Rate Changes Impact Inflation
Federal Reserve raises its benchmark federal funds rates to address rising inflation risks. This effectively increases the risk-free reserve in the financial system and limits the money supply for riskier assets. In contrast, a central bank that lowers its target interest rates effectively increases the money supply to buy risk assets.
Rising interest rates can discourage consumers and businesses from spending large-ticket items such as capital and housing equipment. Rising interest rates can also have a negative impact on asset prices. This reverses the wealth effect and makes banks less cautious when lending. Rising interest rates indicate that inflation expectations will be further reduced by the central bank continuing to tighten its monetary policy.
Problems with Using Interest Rates To Control Inflation
The policymakers respond to changes in the economic outlook with a delay. Their policy changes take time to impact inflation trends. These lags force policymakers to attempt to predict future inflation trends before deciding on the rate level for the current. However, backward-looking inflation statistics cannot be used to gauge the Fed's compliance with its inflation target. These numbers can fluctuate widely in the face of economic shocks that may sometimes be temporary and others less so.
Interest Rates are a Monetary Policy Instrument
The federal funds rate is the fundamental monetary instrument the Federal Reserve uses. The target rate for the federal funds rate has been in place since 2008. It is the interest rate at which banks lend money to one another for one night. Open market operations, also known as purchases and sales of securities, have traditionally been the method of choice for the Federal Reserve to alter the supply of banking system reserves and maintain the desired level of the federal funds rate. To guarantee the financial health of banks, reserve requirements were instituted. Because of this, there was a rise in the need for reserves.
After the 2008 financial crisis, bank regulation was shifted to capital buffer requirements for banks and stress tests to ensure their long-term solvency. The Fed announced a new policy in 2019 to target the federal funds rate along with two other rates. This is the interest on reserve balances rate, which the Fed pays banks to overnight deposit money into their Fed accounts. This floor is effective under the federal fund's rates. As an additional tool, overnight reverse purchase agreements pay a slightly lower interest rate to participants in the non-bank money markets for overnight deposits. The Federal Reserve abolished reserve requirements for banks and depository institutions in 2020.
Relationship
Quantity Theory of Money states that money supply and money demand determine inflation. Inflation will rise if the money supply is increased. Conversely, a decrease in money supply will lead to inflation decreasing. This principle can analyze the relationship between inflation and interest rate. If the interest rate is high, the money supply decreases, so inflation falls. Conversely, a lower or higher interest rate will result in a greater supply of money, which can lead to inflation, which is an increase in demand.
The central bank raises the interest rate to control high inflation. The cost of borrowing goes up when the interest rate rises. This makes borrowing more expensive. The money supply will decline, and borrowing will decrease. The market will see a drop in money supply, resulting in people buying more expensive goods and services. The collection of goods and services will remain constant. This will lead to a decrease in demand, resulting in a price fall.
