Will the Fed curb inflation? Here’s why Idaho economist says the Fed alone cannot fix it

Despite all its money, it may not have the power. The Fed’s efforts to constrain inflation are likely to fall short.

The Federal Open Market Committee, the Federal Reserve’s monetary policy group, has announced an increase in its target federal funds rate. This is the first increase in this official rate since 2018. But despite the change in official policy, interest rates on short-term U.S. Treasury bills remain near zero, and longer-term borrowing rates for businesses and homeowners remain well below their historical averages.

The situation suggests that the Fed has lost its edge. That is, monetary policy may no longer be able to combat inflation.

Why? Excessive fiscal spending has weakened the Fed’s already imperfect influence on the economy.

Historically, the Fed reduced inflationary pressure through what is called open market operations — the purchase and sale of bonds in the inter-bank lending market. In this process the Fed raises the cost of money to banks, which in turn is supposed to slow lending, economic growth and pricing pressure.

Beginning with the financial crisis of 2008, and expanding during the COVID shutdowns, the Fed did much more than just intervene in the banking markets. It purchased many long-term Treasury bonds and government-backed mortgage bonds. Through both open-market operations and direct bond purchases, the Fed rapidly increased what is called the monetary base. This increase in the availability of credit and money corresponded with a rapid increase in government spending.

Recent research from John Cochrane of the Hoover Institution at Stanford University demonstrates that the high rate of inflation we see today is due more to government spending then Fed policy. Professor Cochrane’s work shows both theoretically and empirically why rapid increases in government spending, like that which we saw in early 2020, produce high rates of inflation that the Fed can do little to constrain.

The Fed’s efforts to combat inflation with higher bank rates (through open-market operations) and higher long-term interest rates by selling the Treasury and mortgage bonds it bought earlier will only serve to raise the cost of financing government budget deficits. Only a constraint on direct spending will reduce the rate of growth in credit and money that is causing inflation.

The power’s in Congress. The Fed can’t stop inflation if the government doesn’t stop spending.

Peter Crabb is a professor of finance and economics at Northwest Nazarene University in Nampa, Idaho. prcrabb@nnu.edu