The Fed can slow this growth by tightening the money supply, which is the total amount of credit allowed into the market. The Fed's actions reduces the liquidity in the financial system, making it becomes more expensive to get loans. This slows economic growth and demand, which puts downward pressure on prices.
What Tools Does the Federal Reserve Use to Control Inflation?The Federal Reserve has several tools it traditionally uses to implement contractionary monetary policy if it suspects inflation is getting out of hand. First, the Fed can raise the Reserve requirement. This is the amount banks must keep on reserve at the end of each day. Raising this reserve keeps money out of circulation. Second, the Fed could raise the discount rate. This is the interest rate the Fed itself charges to allow banks to borrow funds from the Fed's discount window.
The Fed rarely modifies these two tools. Instead, it usually changes the Fed funds rate. This is the interest rate banks charge for loans they make to each other to maintain the Reserve requirement. This is much easier for the Fed to modify, and it has the same effect as changing the Reserve requirement and discount rate.
Federal Reserve Chairman Ben Bernanke said the most important tool the Fed has to control inflation is to manage the public's expectations. Once people anticipates inflation, they create a self-fulfilling prophecy. They plan for future prices increases by buying more now, thus driving up inflation even more. Bernanke said the mistake the Fed made in controlling inflation in the 1970s was its stop-go monetary policy. It raised rates to combat inflation, then lowered them to avoid recession. This volatility convinced businesses to keep their prices high. It wasn't until Federal Reserve Chairman Paul Volcker raised rates, and kept them there despite the 1981 recession, that inflation was finally controlled.
The next Chairman, Alan Greenspan, followed Volcker's example. During the 2001 recession, the Fed lowered interest rates to end recession. By mid-2004, it slowly but deliberately raised rates to avoid inflation. Greenspan heavily signaled the stock market and told investors exactly what he planned to do, thus avoiding another recession. This reassured market investors, who kept investing and spending despite higher interest rates. For more on how the Fed manages the expectations of inflation, see Past Fed Funds Rate.
How Well Is the Fed Controlling Inflation Now?Since 2007, the Fed has had its hands full preventing, not inflation, but a global depression. During the banking crisis, the Fed created many innovative programs that quickly pumped trillions of dollar of liquidity into the economy to keep banks solvent. Many were worried that this would create inflation once the global economy recovered. However, the Fed developed an exit plan to wind down the innovative programs. For example, it created a Certificate of Deposit program to mop up excess credit in banks.
A new tool the Fed uses to manage inflation is inflation rate targeting. The Fed actually encourages a moderate inflation rate that it announces. Right now that rate is 2%, for the core inflation rate. That's the measurement of inflation excluding gas and food prices, which can be very volatile. A little bit of inflation can encourage growth. That's because people expect prices to rise, so they buy more now to avoid future price increases. This generates the demand needed for a healthy economy.
Inflation rate targeting also means that the Fed won't allow inflation to rise much above the 2% core inflation rate. If inflation rises too much above the target, the Fed will implement contractionary monetary policy to keep it from spiraling out of control. To find out how well the Fed is controlling inflation, see Current Inflation Rate. Article updated March 7, 2012