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The Federal Reserve’s Role in Controlling Costs

Inflation in the U.S. is at a 30 year high, and many Americans have noticed a cost increase in the items that they purchase every day. Last month, President Biden renominated Jerome Powell to a second term as Federal Reserve chair and combating inflation will be Powell’s top priority entering this term, or at least the priority that people care about the most. There are several levers that the Fed can pull to attempt to combat this inflation. As Powell announced last month, quantitative easing is the lever that they plan to pull right now. Quantitative easing, or QE, is a Fed program that purchases financial assets from the market in order to get more cash into the American economic system. The Fed first employed QE during the 2008 financial crisis and has continued it on and off until significantly ramping up last year to combat the effects of the COVID-19 pandemic.

Injecting more money into the economic system via QE makes it easier and more likely for consumers and businesses to spend money. Banks are more likely to make loans and offer better terms with the extra cash that they have. This encouragement action is designed to oppose the depressive effects of a pandemic, or any economic crisis. However, a high presence of money in the economic system over time could lead to a devaluing of that money, or an inflated price of goods.

The other major lever that the Fed can pull to effect inflation is changing the federal funds rate. This is the interest rate that banks earn on their reserve currencies held by the Fed. A high federal funds rate encourages banks to hold more reserves at the Fed because they can get a better return on those reserves. And a low federal funds rate means the opposite, so banks would want to keep less reserves at the Fed, meaning more money in the larger economy. At the beginning of the pandemic, the Fed dropped the rate to nearly zero, for similar logic to QE. Putting money into the economy will get more people to spend and oppose the economic effects of the pandemic.

The Fed currently does not plan to raise the federal funds rate to combat inflation and President Biden seems largely aligned with the plan to tackle inflation by tapering QE instead. This explains why Powell, originally a Trump appointee who has recently come under criticism from some Democrats, was reappointed by Biden. Presidents, no matter which party, tend to prefer that the federal funds rate be low. If banks do not hold as much reserve currency, people tend to spend more and the stock market tends to be higher, typically leading to politically better outcomes for presidents.

It is still unclear how well tapering QE will manage inflation. There is, of course, disagreement on what should be done, and it will likely be years before we can definitively tell how successful the current Fed plan is, and even then it still may be unclear. One thing is for certain is that prices are going up, and consumers are feeling it. You can read more about it in Kathryn Whitney’s article on the High Cost of the Holidays.

Photo credit: https://www.federalreserve.gov/aboutthefed/aroundtheboard/history-buildings.htm

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