By Dr. Harold A. Black
Apparently, the federal czars fitfully trying to manage the economy have forgotten that economics tells us that prices are determined by changes in both supply and demand. Only the Federal Reserve appears to be participating in fighting inflation while the Biden administration is acting just the opposite. The Fed is trying to lessen aggregate demand by raising its Fed funds target rate and cutting back on its securities portfolio. Although the media keeps saying that the Fed raises interest rates, it controls the movement of only two rates: the fed funds rate and the rate on Treasury bills. The market determines the rates on everything else. If the Fed wants to attack inflation, it tries to curtail bank lending by decreasing bank reserves. This reduces the amount that banks can lend. The fed funds rate is the rate on reserves lent by depository institutions to other depository institutions. In our economy, the banks hold reserves at the Fed and can lend “excess reserves” – those reserves that are in excess of what the Fed requires. The excess reserves when loaned out are the primary source of the nation’s money supply. If the Fed wants to slow down the economy, it raises the Fed Funds rate by selling Treasury securities to the banks. The banks pay for the securities with their reserves, causing reserves to fall. This decrease in bank reserves means that less money can be lent out and the money supply falls. The decrease in the supply of reserves causes the Fed Funds rate to increase and the sale of Treasury securities causes the rate on Treasuries to increase as well. The Fed funds rate and the Treasury bill rates are benchmark rates and the rates charged by lenders are tied to those rates. If the banks’ cost of funds increases, the banks will raise their lending rates. This increase in rates makes it more expensive for consumers and businesses to borrow so they should borrow less. Less borrowing translates to less spending and the overall decrease in demand lowers prices and lower prices mean lower inflation.
However, inflation can also be fought by addressing the other factor that sets prices, namely supply. Prices can be lowered by decreasing demand, increasing supply or a combination of the two. Much of today’s inflation is caused by a decrease in the supply of energy and the Fed’s increase in the money supply. Biden has said, “I want every American to know that I’m taking inflation very seriously and it’s my top domestic priority.” Really? My Dad once said, “that sounds good – if you are interested in sounds.” Biden actions belie his words. Deliberately decreasing the supply of oil and signing trillion dollar spending bills increase aggregate demand are inflationary.
If the administration were serious about inflation – which it isn’t – it would aggressively move to increase the supply of oil and natural gas. It would also decrease government spending. Yet the Biden administration continues to pursue inflationary policies by restricting the supply of energy and pushing for another trillion dollar spending bill. These actions will make inflation worse. Thus, while the Fed is attempting to slow down inflation by decreasing demand, Biden is doing the opposite by restricting the supply of energy and trying to spend more. The result of his actions coupled with the Fed’s is analogous to driving a car with one foot on the accelerator while the other foot is on the brake.
Biden is forcing the Fed to act more aggressively than otherwise. Biden and his administration have demonstrated that they do not care about the crippling effects of higher energy costs on businesses – especially small businesses – and to consumers – especially low income consumers. They obviously don’t want to alter their agenda. If they stopped their inflationary actions, the Fed could likely achieve its soft landing – decreasing inflation without triggering a recession. But it looks like the administration is trying to keep the left happy while placing the burden of stopping the inflation solely on the Fed.