The Fed may have to blow up the economy to get inflation under control.
In the wake of the recent inflation rate of 3.5 percent, the Federal Reserve has adopted five policies intended to bring inflation down to reasonable rates. Policy No. 1 is to lower short-term interest rates. Inflation has been stubbornly high and there are signs that inflation could start to grow above the Fed’s goal of 2 percent in the months ahead.
What will happen to the economy in the future when inflation starts hitting 3.5 percent? To find out, I’ve created an interactive inflation-vs-economic growth graph that takes into account the cost of living, and gives the Fed some help in reducing the inflation rate.
What You Need to Know About the Fed’s Inflationary Policies
Here’s more information on these policies.
Policy No. 1: Lowering Interest Rates
Falling nominal interest rates in a growing economy are a stimulative force for the economy. There are several reasons why the Fed should keep interest rates low in order to provide enough stimulus to growth.
1. Low interest rates have the effect of encouraging more investment.
A low interest rate environment also reduces the risk of inflation. Since inflation is not inflationary, lower rates mean that there is less reason for investors to worry and invest in risky assets.
2. Low rates also give consumers more confidence to spend and drive economic growth.
A period of low rates also means that the economy has less excess capacity. Consumer spending grows more quickly when interest rates are low, so low interest rates help to boost economic growth.
3. Lowering interest rates reduces the potential cost of financing future debt.
This means that investors aren’t forced to take on excessive credit risk when rates are low. Lower interest rates also mean that banks can keep less expensive and safer loans on their books.
4. Lowering interest rates reduces the cost of financing existing debt.
The higher the interest rates are, the more interest-bearing debt is being paid in the form of higher interest on debt.