Predicting Federal Reserve Policy

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The Iowa Electronic Markets

Predicting Federal Reserve Policy

Economics Curriculum Using the IEM

Federal Reserve Monetary Policy Market

September 2000

Learning Objectives

Predicting Federal Reserve Policy

Prior to this module, students should be able to:

  • Describe and explain the economic significance of inflation, unemployment, and real GDP growth.

  • Analyze and explain the relationship among inflation, unemployment, and real GDP using the aggregate demand/aggregate supply model.

  • Describe the goals and objectives of Federal Reserve policy and the Federal Reserve’s policy instruments.

  • Use the aggregate demand/aggregate supply model to describe and explain how the Federal Reserve uses its policy instruments (in particular, the Federal Funds rate) to meet its policy goals and objectives.

Learning Objectives

At the end of this module, students should be able to:

  • Summarize current national and regional economic conditions based on analysis of relevant macroeconomic data.

  • Analyze and describe current economic conditions using the aggregate demand/aggregate supply model.

  • Explain the current policy goals and objectives of the Federal Reserve with respect to inflation, the unemployment rate, and real GDP growth.

  • Use the aggregate demand/aggregate supply model to describe and predict Federal Reserve policy based on current economic conditions and the Federal Reserve’s policy goals and objectives.

Important Aspects of the Module

  • Students retrieve and analyze economic data to construct a summary of current economic conditions in the economy.

  • Students link economic data and current events to economic theory.

  • Students combine data, theory, and analysis to construct policy predictions based on current policy goals and objectives.

Lecture Outline

Predicting Federal Reserve Policy

1. Introduction: The Relationship Between Economic Policy and the State of the Economy

Policy Goals

Recession and Inflation

Offsetting Shifts in Aggregate Demand

Offsetting (Negative) Shifts in Aggregate Supply

A Self-Regulating Macro-Economy? – Potential GDP and the Natural Rate

The “New Economy” and the Role of Economic Policy

2. Role of the Federal Reserve

Policy Goals and Objectives

Policy Instruments: The Fed Funds Rate

FOMC Meetings

Effects of Federal Reserve Policy

What can Fed Policy Accomplish?

3. Predicting Federal Reserve Policy
Summarizing Current Economic Conditions

Recent Federal Reserve Behavior

Predicting Federal Reserve Policy

Example: The November, 1999 FOMC Meeting and the IEM FedPolicy Market

4. Summary

Lecture Notes

Predicting Federal Reserve Policy

Note: The material in this section is adapted from material published on the Board of Governors of the Federal Reserve Web site.
Board of Governors Home Page
Web links for additional related information are provided below:
The Structure of the Federal Reserve System
Purposes and Functions of the Federal Reserve

1. Introduction: The Relationship between Economic Policy and the State of the Economy.
Goals of Monetary Policy
Monetary policy has two basic goals: to promote "maximum" output and employment and to promote "stable" prices. These goals are prescribed in a 1977 amendment to the Federal Reserve Act of 1913.
In the long run, the level of output and employment in the economy depends on factors other than monetary policy. These include technology and people's preferences for saving, risk, and work effort. So, "maximum" employment and output means the levels consistent with these factors in the long run. But the economy goes through business cycles in which output and employment are above or below their long-run levels.
Even though monetary policy can't affect either output or employment in the long run, it can affect them in the short run. For example, when demand contracts and there's a recession, the Fed can stimulate the economy—temporarily—and help push it back toward its long-run level of output by lowering interest rates. Therefore, in the short run, the Fed and many other central banks are concerned with stabilizing the economy—that is, smoothing out the peaks and valleys in output and employment around their long-run growth paths.
Although monetary policy cannot expand the economy beyond its potential growth path or reduce unemployment in the long run, it can stabilize prices in the long run. Price "stability" is basically low inflation—that is, inflation that's so low that people don't worry about it when they make decisions about what to buy, whether to borrow or invest, and so on.
In practice, the Fed, like most central banks, cares about both inflation and measures of the short-run performance of the economy.
The Federal Reserve’s Concern with Inflation
The Federal Reserve is concerned about high inflation because it can hinder economic growth. For example, when inflation is high, it also tends to vary a lot, and that makes people uncertain about what inflation will be in the future. That uncertainty can hinder economic growth in a couple of ways—it adds an inflation risk premium to long-term interest rates, and it complicates the planning and contracting by businesses and households that are so essential to capital formation.
High inflation also hinders economic growth in other ways. For example, because many aspects of the tax system are not indexed to inflation, high inflation distorts economic decisions by arbitrarily increasing or decreasing after-tax rates of return to different kinds of economic activities. In addition, it leads people to spend time and resources hedging against inflation instead of pursuing more productive activities.
Federal Reserve Policy: Offsetting Shocks to the Economy
Output, employment, and inflation are influenced not only by monetary policy, but also by such factors as our government's taxing and spending policies, the availability and price of key natural resources (such as oil), economic developments abroad, financial conditions at home and abroad, and the introduction of new technologies. In order to have the desired effect on the economy, the Fed must take into account the influences of these other factors and either offset them or reinforce them as needed. This isn't easy because sometimes these developments occur unexpectedly, and because the size and timing of their effects are difficult to estimate.
The 1997-98 currency crisis in East Asia is a good example. Over this period, economic activity in several countries in that region either slowed or declined, and this reduced their demand for U.S. products. In addition, the foreign exchange value of most of their currencies depreciated, and this made Asian–produced goods less expensive for us to buy and U.S.–produced goods more expensive in Asian countries. By themselves, these factors would reduce the demand for U.S. products and therefore lower our output and employment. As a result, this was a factor that the Fed had to consider in setting monetary policy.
Another example is the spread of new technologies that can enhance productivity. When workers and capital are more productive, the economy can expand more rapidly without creating inflationary pressures. During the past decade, there have been indications that the U.S. economy may have experienced a productivity surge, perhaps brought on by computers and other high-tech developments. The issue for monetary policymakers is how much faster productivity is increasing and whether those increases are temporary or permanent. The answer to that question may determine to what extent the Federal Reserve should intervene in the economy.
2. Role of the Federal Reserve
Monetary Policy Goals
The Federal Reserve’s monetary policy objective is to promote economic growth and high employment by maintaining stability in prices, interest rates, financial markets, and foreign-exchange rates.

Tools of monetary policy and Interest Rates

The Fed can't control inflation or influence output and employment directly; instead, it affects them indirectly, mainly by raising or lowering short-term interest rates. The Fed affects interest rates mainly through open market operations and the discount rate, and both of these methods work through the market for bank reserves, known as the federal funds market.

The Federal Funds Market and Monetary Policy
From day to day, the amount of reserves a bank has to hold may change as its deposits and transactions change. When a bank needs additional reserves on a short-term basis, it can borrow them from other banks that happen to have more reserves than they need. These loans take place in a private financial market called the federal funds market. The interest rate on the overnight borrowing of reserves is called the federal funds rate or simply the "funds rate." It adjusts to balance the supply of and demand for reserves. For example, an increase in the amount of reserves supplied to the federal funds market causes the funds rate to fall, while a decrease in the supply of reserves raises that rate.
The major tool the Fed uses to affect the supply of reserves in the banking system is open market operations—that is, the Fed buys and sells government securities on the open market. Suppose the Fed wants the funds rate to fall. To do this, it buys government securities from a bank. The Fed then pays for the securities by increasing that bank's reserves. As a result, the bank now has more reserves than it is required to hold. The bank can then lend these excess reserves to another bank in the federal funds market. Thus, the Fed's open market purchase increases the supply of reserves to the banking system, and the federal funds rate falls. When the Fed wants the funds rate to rise, it does the reverse; that is, it sells government securities. The Fed receives payment in reserves from banks, which lowers the supply of reserves in the banking system, and the funds rate rises.
The FOMC and Federal Reserve Policy
The Federal Open Market Committee (FOMC), consisting of seven members of the Board of Governors of the Federal Reserve System, the president of the Federal Reserve Bank of New York, and four additional Federal Reserve bank district presidents, holds eight regularly scheduled meetings per year to direct the conduct of open market operations in a manner designed to foster the long-run objectives of price stability and sustainable economic growth.

The Effects of Monetary Policy on the Economy
The point of implementing policy through raising or lowering interest rates is to affect people's and firms' demand for goods and services. Changes in real interest rates affect the public's demand for goods and services mainly by altering borrowing costs, the availability of bank loans, the wealth of households, and foreign exchange rates. For example, a decrease in real interest rates lowers the cost of borrowing and leads to increases in business investment spending and household purchases of durable goods, such as autos and new homes. In addition, lower real rates and a healthy economy may increase banks' willingness to lend to businesses and households. This may increase spending, especially by smaller borrowers who have few sources of credit other than banks.
Lower real rates make common stocks and other such investments more attractive than bonds and other debt instruments; as a result, common stock prices tend to rise. Households with stocks in their portfolios find that the value of their holdings has gone up, and this increase in wealth makes them willing to spend more. Higher stock prices also make it more attractive for businesses to invest in plant and equipment by issuing stock. In the short run, lower real interest rates in the U.S. also tend to reduce the foreign exchange value of the dollar, which lowers the prices of the exports we sell abroad and raises the prices we pay for foreign-produced goods. This leads to higher aggregate spending on goods and services produced in the U.S. The increase in aggregate demand for the economy's output through these various channels leads firms to raise production and employment, which in turn increases business spending on capital goods even further by making greater demands on existing factory capacity. It also boosts consumption further because of the income gains that result from the higher level of economic output.

3. Predicting Federal Reserve Policy
When predicting Federal Reserve policy, it is important to understand the Federal Reserve’s policy objectives and the current state of the economy. For example, if inflation is rising and economic statistics indicate persistent economic growth, the Federal Reserve is likely to raise interest rates to slow spending in the economy and reduce inflationary pressures.
When deciding on policy changes, the Fed looks at a variety of indicators of the future course of output, employment, and inflation. Among the indicators are measures of the money supply, real interest rates, the unemployment rate, nominal and real GDP growth, commodity prices, exchange rates, various interest rate spreads (including the term structure of interest rates), and inflation expectations surveys.
The Fed balances the current state of these economic indicators against its policy goals and future expectations of economic activity derived from econometric models. For example, during 1999 and into 2000 the Fed became increasingly concerned about the possibility of future inflation arising from tight labor markets and rising consumer and business spending, despite few signs of current inflation. While initially the Fed, and in particular Alan Greenspan, supported keeping interest rates steady – citing increasing labor producivity that helped to keep labor costs and inflation low – the Fed eventually raised interest rates on multiple occasions in late 1999 and early-to-mid 2000 to slow the economy.
Predicting future Federal Reserve monetary policy changes requires (1) an understanding of the Federal Reserve’s policy objectives, and (2) a comprehensive picture of the current economic conditions in the macroeconomy. As new information is received on economic conditions in the economy, predictions of upcoming Federal Reserve policy actions can change, especially during periods when the future course of economic activity is uncertain. In these cases, each new piece of economic data that is released may play a critical role in determining Federal Reserve policy actions.
Note: For an example of how contract prices in the Iowa Electronic Markets change during such periods, please see the Powerpoint slides that accompany this curriculum guide.

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