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Why Fed Rates Affect Inflation

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When the Fed drops its federal funds rate, economists across the world shudder as they see the spectre of inflation peer over the horizon. You ever wonder why that is? The answer is quite simple but will come in two parts. First, a brief refresher on supply and demand, followed by how that and the Fed’s lowering of rates may bring on inflation. Before we begin, I want to make note that everything has been simplified from what’s actually going on. Everything is very complicated in reality but you can explain the gist fairly easily if you’re willing to take some liberties. Those who have a background in economics and know all the intricacies will see some inaccuracies, but they are there to make the explanation smoother. A basic understanding is far better than none at all.

Supply & Demand 101

Simplistically, economists believe that supply and demand will dictate price. If you have more supply with the same demand (surplus), the price goes down. If you have less supply with the same demand (scarcity), the price goes up. If demand goes up with the same supply, price goes up, and vice versa. You’ll see this represented with supply and demand “curves” with the price at where the two intersect. There’s far more to it than that but that’s enough to go on. (it’s actually quite cool if you’re interested, google up some more info)

Fed Target Rate

When mainstream media folks talk about the Fed lowering the federal funds rate, what they’re really talking about is the Fed lower its target rate. The Fed is like a puppet-master and the banks are its puppets. When the Fed says it wants to lower the target rate, it’s really saying that it’s going to be putting more money into the market to lower the cost of it. It’s like a puppetmaster putting on a good show, a twist of a finger here, a lift of the wrist there, and before you know it you have yourself a Broadway musical. The Fed’s “twist of a finger” is sending additional funds to banks that may be low on reserves.

Inflation!

Ideally, the target rate drives the Fed to only put as much additional funding as is needed to keep the economy humming along and banks able to fund their work. Unfortunately, there’s a lag between when the Fed begins acting and when the effects take hold. The fear of inflation is founded in the fact that if the rate is set too low and too much additional funding is pumped into the system, banks find themselves with more than they need.

What happens if they have more money than they need? They lend it out at cheaper prices! (more supply than demand) When consumers get more money, they will spend more money. When they spend more money, demand on goods and services will go up. As demand increases, sellers of products and providers of services will increase their rates… which is inflation.

Inflation is not bad. Moderate inflation is normal and expected. It’s a sign that goods and services are in demand, consumers are financially strong enough to support increased prices, and a signal that the economy is strong.

High inflation is bad. It’s bad because it hinders economic growth. When inflation is high, investors will demand higher rates of return for their savings and so borrowers of money, business and such, will have to pay more to borrow money. If they pay more, the pace of growth slows down. The economy slows down, inflation will settle, and we continue the cycle all over again.

That’s (simplistically) why the Fed lowering rates can lead to high inflation.

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2 Responses to “Why Fed Rates Affect Inflation”

  1. Very well put… I’ve tried to explain this a couple times and it’s hard to put it as simplistically as you did.

  2. Brad says:

    “Inflation is not bad”

    So we are told, though that is wrong. Every bit of inflation makes whatever money you currently have be worth less. We have come to accept “low levels” of inflation, but that doesn’t mean they are good!


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