How does the Fed fight inflation?

A May 10 government report showed that annual inflation in the United States dropped to 4.9 percent in April, the 10th consecutive month of decline. The report from the Bureau of Labor Statistics came a week after the Federal Reserve announced a 0.25 percent increase in its short-term borrowing rate, its latest move in a yearlong fight to rein in consumer prices. While the inflation rate has dropped significantly since peaking at 9.1 percent last summer, it remains well over the Fed’s 2 percent target. Consumers and suppliers are left struggling to make ends meet in an overheated economy.

What is inflation, anyway? Inflation is a broad increase in prices over time. Practically, that means your dollar doesn’t buy as much as it did before. Demand-pull inflation is when demand grows faster than supply can keep up and producers respond by raising their prices. Cost-push inflation is when higher production costs drive supply down and prices up. America is currently experiencing both kinds of inflation.

What can the Federal Reserve do about it? Interest rates are the primary means the Fed uses to control inflation. When the Fed raises government interest rates, it incentivizes banks to raise their own rates. Higher interest rates increase the cost of borrowing, which in turn puts downward pressure on demand. Consumers and businesses are less likely to borrow and spend money with increased rates, effectively diminishing the amount of money in circulation.

How did COVID-19 affect inflation? Government during the Trump and Biden administrations injected trillions of dollars into the economy during the pandemic. Stimulus checks boosted demand as Americans spent even more money on goods. The Federal Reserve also lowered interest rates to near zero to encourage borrowing and spending.

Is the war in Ukraine a factor? Russia’s invasion of Ukraine has slowed post-pandemic recovery by introducing more imbalance to the global and national economies. The war has caused shortages and price increases in raw goods and energy. The spike in energy prices also increases the cost of manufacturing and shipping goods worldwide.

Why isn’t the Fed’s goal to have zero percent inflation? Zero ­inflation increases the risk of an economy falling into deflation. In deflation, lower prices lead to decreased production and wages, which reduces prices even further, potentially triggering a recession. The Fed believes 2 percent inflation allows for greater price stability and provides a buffer for adjusting to changing economic conditions.