does the Fed fight inflation?
How does a rate increase by the Fed stop/affect the inflation?
-- Kevin Yield-Curve
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
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
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.
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