How can the Federal Reserve control inflation?


Answer: The Federal Reserve has a "dual mandate" to both keep prices stable and maintain the highest level of sustainable employment. Controlling inflation falls into the scope of price stability. The Fed has three main tools to achieve this goal. First, they can change the Federal Funds Rate which is the interest rate used by banks for inter-bank lending and is the foundation for interest rates more broadly. An increase in the Federal Funds Rate, will cause interest rates to increase for loans, mortgages, credit cards, etc. The higher costs of interest rates cause prices to decrease. Second, the Fed can set expectations for path of the Federal Funds Rate via announcements from Federal Open Market Committee (FOMC) and "Fed Speak" from individual Fed governors. These updates and commentary are based on the Feds marcoeconcomic forecasts and the individual opinions of the Fed governors. These expectations can influence the publics expectation for inflation and therefore the actual path of inflation. Lastly, the Fed has many technical tools for influencing credit markets and the interest rates on government bonds. These tools involve buying/selling US treasuries or providing assurances to select credit markets. These actions can tighten/loosen these credit markets and therfore indirectly influence actual interest rates. In summary, all three tools used by the Fed play a part in the strategy for controlling inflation.