How the Fed Targets Inflation and Employment … and Why it Matters

The U.S. Federal Reserve (Fed) has been in the news a lot lately amid high inflation and the emergence of potential cracks in the banking system. But what exactly is the Fed trying to achieve, and how does it use its tools and policies to affect the U.S. economy? 

The Fed plays a major role in maintaining the stability of the economy by pursuing two main goals: keeping inflation low (but still positive) and employment high. In this article, BDO Wealth Advisors’ investment committee explains how the Fed seeks to achieve these goals and the ripple effects Fed policy can have on the economy.

But first, why worry about inflation?

Inflation means higher prices for goods and services, which puts a strain on household budgets and erodes wealth. When prices are high and volatile, families and businesses have a hard time planning for the future. From the perspective of individuals, the money in college savings accounts, IRAs, or 401(k)s doesn’t go as far. And for businesses, it may be difficult to hire or make significant investments when the fair value of such investments isn’t clear. This can be dangerous, because people and businesses may limit their spending and invest more conservatively, which can lead to declining economic growth.   

While high inflation rates cause concern, economists generally agree that low but positive long-term inflation rates—about 2%—are typically symptomatic of a healthy, growing economy. While deflation (declining prices) may sound appealing, deflation can signal a downturn in the economy. As prices decrease, businesses earn less, thus putting downward pressure on wages. Consumers may delay purchases as they wait for prices to decline. When businesses and employees earn less, they may struggle to pay bills and loans on time, leading to a potential downward spiral that can eventually cause bankruptcies and a stagnant economy.

What can the Fed do to combat inflation?

The Fed seeks to cool inflation by tightening monetary policy, or reducing the amount of money available in the economy. The Fed can do this because it serves as the central bank—a federally mandated institution where other banks can borrow money and deposit their reserves. 

Historically, the Fed has primarily tightened the money supply by raising interest rates. The Fed establishes a minimum interest rate based on the rate that it pays on other banks’ reserves deposited at the Fed. Banks’ deposits at the Fed are essentially risk-free, so banks don’t lend at a rate lower than the rate they receive from the Fed. 

The Fed also establishes a ceiling on how high interest rates go based on the rate it charges banks to borrow money, which is called the discount rate. Banks won’t borrow from anyone at a rate higher than the discount rate. As such, the interest on your bank deposits—essentially loans from you to your bank—also won’t go higher than the Fed’s discount rate. 

In addition to interest rate policy, the Fed also affects the money supply through its balance sheet—by buying or selling securities. When the Fed buys securities like Treasury notes or mortgage-backed securities, its goal is to lower their yields to support the economy. On the flip side, when the Fed shrinks its balance sheet by selling securities, the Fed is seeking to increase yields and tighten the economy.

How do higher interest rates reduce inflation, employment, and the economy more broadly?

Higher interest rates slow borrowing and spending. For example, in 2023, with mortgage rates above 7% and home equity loans topping 8%, fewer people can afford to buy or renovate homes. This puts downward pressure on home prices and limits demand for new home construction, which causes a ripple effect throughout the economy. For example, fewer people buying homes results in less demand for construction workers, home services, washing machines, furniture, and other goods. Likewise, auto loans have breached 6% since the Fed started raising interest rates, so fewer people may be able to afford a new car, enabling the supply at dealerships to catch up with demand and allowing prices to soften. 

Interest rates affect the economy, and particularly workers, in profound ways. As borrowing gets more expensive and demand for goods and services declines, businesses tend to spend less money and the labor market tends to cool. 

Higher interest rates can also lead to bank deleveraging, which can have profound effects on the economy. Banks are required to keep a specific portion of their assets in reserve to help cover obligations to depositors and other creditors that may need to withdraw funds. Banks also must maintain certain ratios of capital to debt. So, when the assets held by banks decline in value (e.g., when long-term debt securities lose value because interest rates have increased) or when banks fear borrowers won’t be able to repay loans, banks will deleverage by raising capital, selling off assets, or making other changes to shore up their balance sheet. Bank deleveraging can lead to a major slowdown in lending and therefore stifle economic activity. 

By tightening the money supply and raising interest rates, the Fed seeks to cool the economy and tame inflation. If the Fed raises rates just the right amount, the economy will cool off just enough to bring inflation down to the Fed’s target of 2% while still maintaining economic growth (this outcome generally would be called a “soft landing”). If the Fed raises rates too much, economic growth may turn negative and the U.S. may enter a recession, which could lead to a challenging business environment, higher unemployment, and fewer job opportunities (this outcome generally would be called a “hard landing”).

What does this mean for today’s economy?

In 2023, the Fed needs to apply enough pressure to calm inflation without triggering a recession that could lead to a significant increase in unemployment. Unfortunately, the Fed can’t use monetary policy to affect the economy with a great degree of precision, because prices and employment also depend on factors outside the Fed’s control. Additionally, the Fed can’t force people to work, and many who left the workforce during the pandemic haven’t returned,  which has contributed to a stubbornly tight labor market despite rising interest rates. On the other hand, a strong employment picture could serve as a buffer to a significant economic downturn. 

The Fed’s challenge isn’t new. Monetary policy is often described as a blunt instrument, but it is the best instrument the Fed has, and over time it has proven effective. The Fed may be approaching the peak of the rate hike cycle in 2023 before pausing to assess the need for further action. We will continue to monitor the Fed’s actions and the state of the U.S. economy.

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