How Will The Federal Reserve Stop Inflation?

[Music] At the most recent meeting of the Federal Reserve Open Market Committee, it was forecast that inflation is due to rise, and they signaled that as a result, rate increases might move forward sooner than they expected. Now, I explained all this in a fairly recent video, so if you're interested in that, head over there and check out that video. But in this video, we are instead going to focus on what central banks actually do and how their actions affect inflation and economic growth.

Now, to understand that, we have to take a step back and see what things were like before the Federal Reserve was set up. So back then, money was mostly what we would call hard money; it's gold, basically. This meant that the amount of money in the economy was tied directly to the amount of gold in that area at that time. So for simplicity, let's imagine two large islands. There are, you know, 5,000 kilograms of gold on island A and 5,000 kilograms of gold on island B. If you wanted to buy something, you needed some of that gold, usually in the form of a gold coin or something like that.

Now, let's say both islands grow potatoes. Obviously, this is very simplified, but bear with me here. If a storm hits island A, ruining the harvest for a year, the cost of potatoes is going to rise. Potatoes now cost more on island A than on island B. So what's going to happen? Well, everyone on island A is just going to go over to island B across the bridge and buy their potatoes over there. When they do this, they're going to take their gold with them to pay for it. So now, island A say only has 2,500 kilograms of gold, and island B has 7,500 kilograms.

So what is this going to do? Well, because the demand for potatoes is now much higher on island B, and all the potatoes are being bought up, the price is going to rise. At the same time, because the demand for island A potatoes has come down so much, the price of those potatoes is going to fall. Now, at some point, island A potatoes become cheaper than those on island B, and we will see the exact same process happen in reverse: gold will flow back from island B to island A.

Now there might be imbalances like this, with gold flowing back and forth several, several times before eventually an equilibrium is found. And with gold shifting so quickly between islands and prices going up and down all the time, you can imagine it would be very hard to build any sort of thriving economy.

So what do we know from this? Basically, we know that the amount of money in an economy has some relationship to the prices of goods in that economy, and that makes sense: more money equals more demand, equals higher prices. So now that we've got that, we can add another layer of complexity, which is banks. No doubt carrying around gold can get heavy. It's also not the greatest idea to have your entire life savings of gold just sitting at your house; it seems like a great way to have your savings stolen.

So instead, you can go and place that gold in the bank, and in return, the bank will give you a way of representing that gold: a piece of paper money, something like that. So you can then give this piece of paper, which represents a certain amount of your gold stored in the bank, to someone in exchange for goods and services. They can then go to the bank and trade in that piece of paper for the amount of gold that the piece of paper is worth. Or on the other hand, the other person can just pass that note on to somebody else, and it goes around and around and around, never actually being traded in for the original amount of gold.

But, you know, everyone is happy to accept it because they can always go at any time to the bank and exchange; they go and get the gold if they want to. Then the other thing the bank can do is they can lend out your gold. But because the gold is heavy and cumbersome to carry around, instead of actually lending the gold out directly, they just give someone some paper money representing the gold that they're loaning out.

So now we've got this system where there's more paper money than actual gold in the bank. Now, surely this is a problem? Well, remember when we said people are just happy to trade the pieces of paper in place of the gold, and that nobody actually goes and gets the gold itself? Well, if that's the case, then it doesn't matter if there's more paper money than gold because the bank never actually has to pay out all that gold.

Now this is called fractional reserve banking, and it is all based on trust that the bank actually has the gold in there. Now, people in another country might not trust that your bank is being responsible with its gold, so they won't be happy to accept your banknote in exchange for goods and services. They will instead want you to pay with the actual gold, meaning that while banking solves some problems domestically, you still have the problem of gold and therefore money flowing between countries and causing prices to be unstable.

So what if, instead of having all the banks issuing banknotes against gold reserves, we instead issued currency against the trust in the country as a whole, effectively making a national currency? This currency is issued by a central bank, and then all of the other banks can hold accounts there.

Now everything works the same way except for one thing: because the supply of currency isn't tied directly to an amount of gold, it can expand and contract as needed. When the central bank thinks there should be more money in the system, they can go out and buy things and simply print new money to pay for those things. Then when they think there should be less money in the system, they can just sell those things back and collect the money.

Now, going back to our island example, remember island A had a storm, so the price of potatoes on island B was rising. Well, instead of letting that money flood to island B, the central bank for island B could just reduce the money supply, thereby reducing demand and bringing prices back down. Or, if the bank was really smart, they could reduce the money supply before the prices went up, meaning that the demand was already lower and the prices wouldn't go up in the first place.

Now, obviously, the world is a lot more complicated than this model that we've built. The Federal Reserve does a lot more than just increasing and decreasing the money supply, and gold doesn't play such a large role in our economy today. However, these ideas do explain the broad strokes of what the Federal Reserve does.

So the Federal Reserve is America's central bank. They have the ability to increase or decrease the money supply, and the way they do that is by increasing or decreasing interest rates. Let's take a look at how that works.

So banks sometimes need short-term loans to settle payments at the end of each day. Now this isn't a huge deal, as money is always flowing around the financial system, kind of like water. If it builds up in one part of the system, it'll eventually flow back down the other way, so the banks are happy to lend to each other. Now they do this through the Federal Reserve.

Now, if there is less money overall in the system, more banks will need to borrow more money. The more demand there is for borrowed money, then the higher the interest rate will be. In that way, you can think about interest rates as the price of accessing money. The Federal Reserve can manipulate these interest rates by increasing or decreasing the amount of money in the system, changing the supply.

So just like we were explaining before, they can do this by buying and selling financial assets. When they buy financial assets, they swap out financial assets for cash, so there's more money in the system, and the banks will have to borrow less, meaning that the interest rates on borrowed money go down. This means the bank's costs are lower, so all of the other interest rates in the economy go down as well.

As those interest rates go down, it means that normal people and businesses can afford to borrow more, meaning they can buy more things, invest in more equipment, and in general, drive the economy along. Now, of course, more money and thus more purchasing of stuff increase demand, so it does mean more inflation. So the Federal Reserve has to be a little bit careful about how they do this. But sometimes inflation can come from other sources, not just the increasing supply of money.

[Music] In 1973, a war broke out between Egypt and Israel, with the Egyptian army crossing the Suez Canal and disrupting the supply of oil from the Middle East. This sent the price of oil skyrocketing around the world and therefore caused the prices of pretty much all products to rise. Combined with a slowdown in economic output, this resulted in inflation reaching as high as 13.5% annually by 1980. As you can imagine, this put immense strain on household budgets as the price of food and clothing skyrocketed.

Now, the chairman of the Federal Reserve at the time was a guy called Paul Volcker. He became known as a giant of the financial industry, with his immense height contributing to this. As well as a way of fighting this inflation, Volcker decided to pump the brakes on the money supply and raised interest rates. In the early 1980s, overnight interest rates were as high as 19.1%.

So this made the cost of borrowing rise dramatically all over the economy. The average 30-year mortgage in the U.S. went as high as 18.63% in 1981. The problem with this was that it caused major economic pain, and it constrained economic activity and effectively put the brakes on the economy. In the first five years of the 1980s, the United States was in a recession for three out of five of those years.

This, unfortunately, is the other side of the coin. So no doubt, very high inflation is bad while it's happening, but as we saw during the 1970s and 1980s, it can be even more painful to get rid of inflation once it's set in. So that is why the Federal Reserve watches inflation numbers so carefully; they need to get ahead of the curve so the inflation doesn't run away from them.

So what does this mean now? Well, we recently saw inflation pick up in the U.S., and in response, the Federal Reserve said that they would likely be moving up their timeline for raising interest rates. This is because they know the way to stop inflation is to have higher interest rates, meaning the money supply is lower.

The Federal Reserve currently has an inflation target of two percent over the long run. This means that they don't expect every quarterly inflation number to be right on the dot of two percent, but over time they aim to have the average reach two percent. So in the past few years, inflation has been below this target, so the Federal Reserve has told us that they will allow inflation to run above two percent for a little while to bring the average up.

However, with the dramatic increase in money supply over the past year and a half, you know, obviously to help people during the lockdown period, it is natural to see inflation creeping in, and we can expect interest rates to start rising at some point in the next couple of years to compensate. But overall, guys, that is a basic layout of how the Federal Reserve works and how they act to control interest rates, which in turn controls the inflation levels.

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