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Dr. Don Taylor, CFA, Bankrate.com advice columnistHow does the Fed fight inflation?

Dear Dr. Don,
How does a rate increase by the Fed stop/affect the inflation?
-- Kevin Yield-Curve

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Dear Kevin,
The Fed establishes a targeted federal funds rate when the Federal Open Market Committee, or FOMC, meets. The FOMC has eight regularly scheduled meetings each year or roughly one every six weeks.

The federal funds rate is the rate at which banks lend out excess reserves to other banks. Bank reserves are a percentage of the funds on deposit at the bank. Reserve requirements are established and monitored by the Fed. Depository institutions must hold reserves in the form of vault cash or on deposit with the Federal Reserve banks.

The Federal Reserve Board, through its open market operations, influences the amount of reserves in the banking system. By doing so, it influences the interest rate on these loans. (The influence part is why it's a targeted rate.) Higher interest rates on federal funds raise the bank's cost of money, necessitating higher interest rates on bank loans to customers. That's why you see the prime rate move in lock step with changes in the targeted fed funds rate.

Higher short-term interest rates put a damper on commercial and consumer borrowing. That means less growth in the money supply. With less money in the economy, there's less upward pressure on prices. The classic definition of inflation is "too much money chasing too few goods." Increases in the fed funds rate work on the too-much-money part of the equation.

It's somewhat counterintuitive, but an increase in the targeted fed funds rate, along with the corresponding increase in other short-term interest rates, can actually result in a decline in long-term interest rates. That's because the Federal Reserve Board is working to reduce inflationary pressures and, by doing so, reduce the size of the inflation premium required by investors in long-term notes and bonds.

To ask a question of Dr. Don, go to the "Ask the Experts" page, and select one of these topics: "financing a home," "saving & investing" or "money."

Bankrate.com's corrections policy -- Posted: April 12, 2006
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