The Federal Reserve System (the Fed) was created by Congress to promote strong employment and ensure that prices remain relatively stable—not rising or falling too fast. The Fed views 2% per year inflation as the right amount. When inflation is too high, money becomes meaningless. Over time, this could lead to an economic breakdown. Right now, inflation is widespread and at record levels. 

Everyone loves the party game/icebreaker “two truths and a lie.”

Can you identify which of the following is NOT true about the Federal Reserve System?

A. The Fed increasing the supply of money circulating in the economy raises inflation.
B. The Fed has no impact on inflation, instead it is Congress, the White House and other economic factors.
C. The Fed increasing interest rates to fight inflation could cause the economy to contract and accelerate a recession.

Let’s take these statements one at a time:

A. TRUTH! The Federal Reserve Bank of St. Louis recently explained: “the money supply is important because if the money supply grows at a faster rate than the economy’s ability to produce goods and services, then inflation will result.” Right now as the U.S. economy struggles to recover from COVID impacts, the Federal Reserve has increased $4.8 trillion in money supply since the start of 2020, according to economists John Greenwood and Steve H. Hanke. 

“Money dominates. Broad money growth drives nominal spending. In normal times most money is created by commercial banks,” Greenwood and Hanke wrote in the Wall Street Journal on July 7. “The Great Inflation started with the Covid-19 pandemic. Commercial-bank balance sheets were in good shape, and, in the early stages of the crisis, Washington encouraged banks to lend more. Banks were ready and willing to create money, and they did. The Fed stepped in to create even more money… Because of their excesses, elevated inflation will continue for some time—at least 12 to 24 months.”

B. LIE! Inflation is the rate at which prices of consumer goods and services are rising. As inflation rises, a person’s purchasing power—her ability to buy goods and services—falls; she is not able to purchase as much as before. The current historically high inflation rate (as measured by the consumer price index) rose 9.1% in June 2022 from 12 months prior. 

As discussed above, the increasing number of dollars circulating in the economy causes the U.S. dollar to be devalued, which drives up inflation. Yes, Congress and the White House can also increase the money circulating in the economy through fiscal stimulus and other policies—additionally putting upward pressure on inflation.

C. TRUTH! Last month, the Federal Reserve started raising interest rates in 75 basis point steps for the first time in thirty years. That means the average price, for example, of obtaining a 30-year mortgage could increase 0.75%—a substantial increase over time costing consumers thousands of extra dollars. The rising costs will not just be seen in mortgages, it will be in loans to businesses, credit cards and other places. Economists expect that the Fed will raise interest rates by another 75 basis points at its next scheduled policy meeting this week, July 26-27. The purpose for raising interest rates is to slow down inflation because it slows down demand for products and services. But because of the increased interest rates leading to a slowdown, this will also result in a contraction in economic activity.  

On July 13, 2022, Economist Desmond Lachman at the American Enterprise Institute wrote an article titled “The Federal Reserve Is Creating A Deep Recession To Stop Inflation.” 

“Last year, the Fed allowed inflation to get out of control and bubbles to form in the equity and housing markets by keeping interest rates too low for too long and by flooding the market with liquidity,” Lachman wrote. “This year the Fed seems to be making the opposite mistake. By rapidly increasing interest rates and withdrawing market liquidity, the Fed risks precipitating a deep economic recession and the bursting of the asset price bubbles.”

Bottom line: 

The Federal Reserve system is supposed to help maintain a healthy U.S. economy. In recent years, it has made some costly mistakes that, while not alone causing the current inflation and economic difficulty felt by Americans, has certainly added to the problem.