Why can’t the Fed just burn money to stop inflation?

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Auditor Brayden Leaverton asks:

If inflation is a problem due to too much money in circulation, why not [the Federal Reserve] just burn money to offset inflation?

Inflation rose 8.3% year-on-year in August; in June, it hit a 40-year high of 9.1%. Of course, the Federal Reserve could do whatever it wants with the money it has, said Ahmed Rahman, an associate professor of economics at Lehigh University.

“They could have a nice bonfire in front of the Federal Reserve Building,” Rahman said. “Kind of a grand gesture of, ‘We’re serious about inflation.’” But before creating such a bonfire, the Fed needs to buy the money back.

“That’s the real key to the goal of curbing inflation,” he explained. “The Federal Reserve can’t just confiscate money willy-nilly.”

The Fed can get money back in two ways, said Laurence Ales, associate professor of economics at Carnegie Mellon University. One is to sell you something, like treasury bonds. These are loans that you paid to the government in exchange for interest payments.

“It’s not about stealing your money — it’s giving you something in return. That’s the nature of business,” Ales said.

The other action the Fed can take is one you’re probably familiar with because it’s happened five times this year: raising interest rates,

“By raising interest rates, people are less likely to borrow money,” said Alan Gin, associate professor of economics at the University of San Diego. “This, in effect, is fundamentally reducing the money supply.”

Take the mortgage market, for example. Fed interest hikes make loans, like mortgages, more expensive. And that stops the flow of money that would have been created through the loan, Ales explained.

Currently, the 30-year fixed rate mortgage is nearly 6.3%, the highest rate since 2008, according to data from Freddie Mac. We are seeing signs that the housing market is cooling, with existing home sales down 0.4% and house prices are rising at a slower pace than at the start of the year.

Let’s go back to the bond market for a moment. Rahman of Lehigh University said that if the Fed burns cash or if cash is accidentally destroyed in a fire, it won’t affect the bond market. What the Fed ultimately wants to do is twofold: “it wants to increase the number of bonds outstanding, [and] he also wants to reduce the supply of money in circulation,” he said.

It therefore increased the amount of the obligations by unloading its balance sheet. Starting in June, the Fed began cutting its holdings by $47.5 billion a month and increased it to $95 billion this month.

“The supply is higher, so the value is lower. That’s how they get people to buy the bonds in the first place: they sell those bonds at a discount,” Rahman said.

Rahman said he thinks the Fed at this point is “doing exactly what it should,” although some believe the Fed should have acted sooner. And others question the Fed’s plans to keep raising rates because it could lead to a recession and increase unemployment.

Gin noted that even if the Fed tries to slow the economy so people don’t buy as many goods, their actions may have less impact on food prices, which have jumped 11.4% year over year.

“Food is affected by external events like the weather, the war in Ukraine and animal diseases,” he said. For example, he said, there is an epidemic of bird flu in the United States which has resulted in the death of nearly 45 million chickens and turkeys, leading to a spike in egg and poultry prices.

Raising interest rates won’t help that, Gin said, although it is already helping in non-food areas, like the housing market.

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