What motivates the Fed. Reserve to raise interest rates to curb inflation at the risk of curbing the economy?

Question

In other words, why doesn't the Federal Reserve consider keeping the economy active more important than preventing inflation?

Answer 1

The Fed's top priority indeed is to prevent inflation.

Nobel Prize winner Joseph Stiglitz confirms this in his book
"The Roaring Nineties". E.g. on p. 70, Stiglitz says:

"Bill Clinton had run for President on a platform of
'Jobs! Jobs! Jobs!'.
But it was clear that this was not Greenspan's major concern;
inflation was more his focus."

Some people believe that this prioritization is because inflation can destroy an economy. Other people believe it's because the Fed's primary underlying purpose is to protect bankers from having to live on the same mediocre wages that everyone else does. ;-)

The Fed's second highest priority is to provide sufficient liquidity and monetary expansion to support growth at a rate that the Fed believes can be sustained in the long run.
(This has nothing to do with environmental sustainability, of course, as far as the Fed is concerned.)

The Fed doesn't have any intelligent idea, as far as I can tell,
about what long-term growth rate is sustainable. Occasionally it
factors in productivity increases (or the lack thereof), but
doesn't seem to focus on them, despite the fact that they
provide almost the only true source of per-capita economic
growth. (I say per-capita because of course population growth
by itself does not cause meaningful economic growth. If
population grows 1% and the economy grows 1%, then
people are no better off.) Since the Fed basically seems to look
just at historical numbers, and since historical figures for
inflation-adjusted (but not population-adjusted?) economic
growth are generally between 1% and 4% in the U.S., the
Fed believes that economic growth of around 3% per year is
sustainable. The Fed seems to believe that anything below 2% shows that the Fed screwed up (or that big-government-loving liberals screwed up), and anything around 4% or higher is a prelude to an inflationary spiral.

So why does the Fed emphasize stifling economic growth and,
more specifically, increasing unemployment to prevent
inflation from spiraling out of control?

During the 1970s, when inflation was often high, the
"experts" thought that they observed an inverse relationship
between inflation and unemployment -- the lower unemployment
was, the higher inflation was. The relationship was graphed
over a small number of years and it became known as
the "Phillips Curve". The experts concluded that when labor
had too much power, it bargained successfully for higher
wages, and higher wages caused prices to rise, which caused
labor to demand higher wages, and so therefore inflation
could spiral out of control.

(Inflationary spirals could also be caused by "printing money",
i.e. allowing overly fast growth of the money supply, but the Fed
generally tries to prevent this keep money supply growth within
a target range. This task is complicated by the fact that with so
many different forms of money (credit cards, electronic transfers,
etc.) neither the Fed nor anybody else really knows the size or
growth rate of the money supply any more. The Fed officially
recognizes 3 different means of calculating money supply
and therefore officially recognizes 3 different numbers,
called M1, M2, and M3, as measures of the money supply. )

Naturally, if inflation is the top priority and economic growth
and the standard of living of the general public are at best
a second priority, then whenver there is a threat of inflation,
the Fed is obligated to stomp on the economic brakes,
driving up unemployment to revent inflationary spirals
such as the ones in Germany (1920s), Argentina (1990s?),
Zimbabwe (today), etc.

The Fed believes, and Alan Greenspan has publicly stated, that
unemployment of at least 5% or 6% (I forget which) is necessary
to keep labor from having enough leverage to get pay increases
that would spark or exacerbate inflation.

Although I'm not a Marxist, I find it very amusing that
when Greenspan declared that 6% unemployment
is "full employment" because anything lower would cause
an inflationary spiral, Greenspan was saying exactly
what Marx said capitalists would do, which was to keep a
"reserve army of the unemployed" to hold down wages.

Given that history seems to show that, once ignited,
inflation can indeed easily spiral upward, it's reasonable
for the Fed to put a high priority on stopping inflation, and
if excess bargaining power by labor were really the main
cause of inflation, then perhaps it would make sense for
the Fed to squash inflation at the cost of slowing wage growth.

However, there are strong reasons to doubt the Fed's estimate of
just how high unemployment must be to keep a lid on inflation.

In fact, there are strong reasons to doubt that wages are the
main factor in inflation (though I have no doubt that wages are
at least one factor)!

First, given the fact that for most of the last 25 (or more?) years
the rich have gotten much richer and the poor and middle class
have increased their income very little, it's hard to take
seriously the Fed's emphasis on keeping down the wages
of the lower and middle class. If the Fed were trying to keep
down income increases among the wealthy as well as among
the lower and middle classes, then the Fed's behavior would
be more credible.

But most damning is something that economists
have stopped talking about: the relationship between
inflation and unemployment that was spotted during
the early 1970s was based on a small number of years
in the past, and it didn't hold up for very long in the future.
During the late 1970s and early 1980s, we had high
inflation even though we had high unemployment.
Conversely, during the Clinton administration, unemployment
fell to 3.8% (far below the 6% that Greenspan declared was
the absolute minimum needed to stifle inflation). Yet
inflation was relatively low.

Even before the 1970s were out, economists recognized
that the "Phillips Curve" didn't fit the data. Their response
was the "inflation-adjusted Phillips Curve".
This was not a curve at all, but a series of curves climbing
upward and rightward on the graph (where one axis of the
graph was inflation and the other was unemployment).

If you plot the inflation and unemployment data, they
simply don't form a curve; there are speckles all over
the graph. Drawing a series of concentric arcs through
a dense field of data is a case of twisting the data to
fit pre-conceptions. Calling this an "inflation-adjusted"
curve is nonsense. It's a cloud, not a curve, and it
shows little, if any, inverse relationship between wages
and inflation.

(Furthermore, the curve itself didn't prove whether rising
wage demands by labor caused inflation, or whether
inflation caused rising wage demands from labor.)

That doesn't mean that 0% unemployment would have no
inflationary effect -- it simply means that most of the time
there are other factors that outweigh unemployment in
determining the overall inflation rate.

One of the other factors is, not surprisingly, the price of
natural resources. And as the labor supply increases while
natural resources supplies decrease, it is highly likely
that that wages have less and less impact on inflation,
while natural resource prices have more and more effect.

I can't tell you what the Fed thinks about this, but I can
make a well-educated guess. The Fed's economists, like
most economists, don't see natural resources as a long-term
constraint on the economy. They know that individual
resources (such as oil) are limited, but they have a religious
belief that there are an infinite number of finite resources,
and therefore we'll never run out.

This is consistent with the Fed's apparent belief that although
natural resource prices cause one-time increases in prices,
but don't lead to inflationary spirals. E.g. if the price of oil
goes up from $25 per barrel to $75 per barrel, that will lead
to a one-time increase in the prices of plastic, gasoline, etc.
But prices will reach a new equilibrium and will not spiral
upward (except when those evil labor bargainers use rising
prices as an excuse to demand higher wages).

Since the Fed believes that only wage increases can cause
inflationary spirals, the Fed uses unemployment (or, more
precisely, interest rates that dampen economic activity and
thus lead to unemployment) as its primary means of preventing
inflationary spirals.

Answer 2

The federal reserve is the central bank of the US. It has the dual role of keeping inflation in check and also to keep the economy up and growing. The fed regulates this by keeping check on the amount of money that goes into the economy by adjusting the lending rate. If it keeps it too short/small then there will be a gush of money into the market, and growth will boom causing inflation. Inflation is counter productive as it erodes savings, a dollar today would be worth lesser in a year if inflation is high. It also depreciates the dollar vis-a-vis other currencies making the dollar cheaper. If on the other hand the fed hikes the rate too high, it risks choking economic growth. This is why the fed meets every month and decides whether to increase of decrease interest rates. The fed looks at a wealth of fundamental economic data to make this decision. The fed chairman gets an update on the economy every 15minutes or so.

Answer 3

Inflation is about having too much purchasing power by the people,when this situation happens there are some steps that must be undertaken to arrest/curb it,among other things include monetary policy and the fiscal or budgetary policy.

Increasing interest rate is a monetary policy that is takeb by the central banks directing the commercial banks to raise the interest rate with the motive to encourage serving ,which ultimately has the effect of reducing the supply of money from the hands of the people and therefore reduces their purchasing power which can therefore conciderably curbs the inflatioon.

Answer 4

I think you raised a very interesting question. I think the Fed's policy simply isn't working under the present set of circumstances. Inflation is not on the rise due to consumerism. It's rising because of the increase in energy cost. It is counterproductive to increase to cost of borrowed money when energy, which is needed to produce and get products to market, is uncontrollably increasing in cost.
A lot of business debt, and personal debt as well, exist from money borrowed years ago when conditions were different. Due to the increase in interest rates that old debt is costing more in interest payments. How does the Fed feel this policy will curb inflation? By increasing unemployment. The Fed chairmen are cold hearted accountants. There's no people in the USA, just a bunch of statistics.

Answer 5

It stems from the basic assumption in capitalism that the economy is revitalized by boosting consumerism. But there must be a limit and somehow savings should be encouraged. I wonder if there's anybody out there brave enough to question said basic assumption (and survive the lynching)