If the fed uses a passive monetary policy during weak economic conditions,

5 Monetary Policy

CHAPTER OBJECTIVES

The specific objectives of this chapter are to:

· ▪ describe the mechanics of monetary policy,

· ▪ explain the tradeoffs involved in monetary policy,

· ▪ describe how financial market participants respond to the Fed's policies, and

· ▪ explain how monetary policy is affected by the global environment.

The previous chapter discussed the Federal Reserve System and how it controls the money supply, information essential to financial market participants. It is just as important for participants to know how changes in the money supply affect the economy, which is the subject of this chapter.

5-1 MECHANICS OF MONETARY POLICY

Recall from Chapter 4 that the Federal Open Market Committee (FOMC) is responsible for determining the monetary policy. Also recall that the Fed's goals are to achieve a low level of inflation and a low level of unemployment. This goal is consistent with the goals of most central banks, although the stated goals of some central banks are more broadly defined (e.g., “achieving economic stability”). Given the Fed's goals of controlling economic growth and inflation, it must assess the prevailing indicators of these economic variables before determining its monetary policy.

5-1a Monitoring Indicators of Economic Growth

The Fed monitors indicators of economic growth because high economic growth creates a more prosperous economy and can result in lower unemployment. Gross domestic product (GDP), which measures the total value of goods and services produced during a specific period, is measured each month. It serves as the most direct indicator of economic growth in the United States. The level of production adjusts in response to changes in consumers' demand for goods and services. A high production level indicates strong economic growth and can result in an increased demand for labor (lower unemployment).

   The Fed also monitors national income, which is the total income earned by firms and individual employees during a specific period. A strong demand for U.S. goods and services results in a large amount of revenue for firms. In order to accommodate demand, firms hire more employees or increase the work hours of their existing employees. Thus the total income earned by employees rises.

   The unemployment rate is monitored as well, because one of the Fed's primary goals is to maintain a low rate of unemployment in the United States. However, the unemployment rate does not necessarily indicate the degree of economic growth: it measures only the number and not the types of jobs that are being filled. It is possible to have a substantial reduction in unemployment during a period of weak economic growth if new, low-paying jobs are created during that period.

   Several other indexes serve as indicators of growth in specific sectors of the U.S. economy; these include an industrial production index, a retail sales index, and a home sales index. A composite index combines various indexes to indicate economic growth across sectors. In addition to the many indicators reflecting recent conditions, the Fed may also use forward-looking indicators (such as consumer confidence surveys) to forecast future economic growth.

Index of Leading Economic Indicators Among the economic indicators widely followed by market participants are the indexes of leading, coincident, and lagging economic indicators, which are published by the Conference Board. Leading economic indicators are used to predict future economic activity. Usually, three consecutive monthly changes in the same direction in these indicators suggest a turning point in the economy. Coincident economic indicators tend to reach their peaks and troughs at the same time as business cycles. Lagging economic indicators tend to rise or fall a few months after business-cycle expansions and contractions.

   The Conference Board is an independent, not-for-profit, membership organization whose stated goal is to create and disseminate knowledge about management and the marketplace to help businesses strengthen their performance and better serve society. The Conference Board conducts research, convenes conferences, makes forecasts, assesses trends, and publishes information and analyses. A summary of the Conference Board's leading, coincident, and lagging indexes is provided in Exhibit 5.1 .

Exhibit 5.1 The Conference Board's Indexes of Leading, Coincident, and Lagging Indicators

Leading Index

1. Average weekly hours, manufacturing

2. Average weekly initial claims for unemployment insurance

3. Manufacturers' new orders, consumer goods and materials

4. Vendor performance, slower deliveries diffusion index

5. Manufacturers' new orders, nondefense capital goods

6. Building permits, new private housing units

7. Stock prices, 500 common stocks

8. Money supply, M2

9. Interest rate spread, 10-year Treasury bonds less federal funds

10. Index of consumer expectations

Coincident Index

1. Employees on nonagricultural payrolls

2. Personal income less transfer payments

3. Industrial production

4. Manufacturing and trade sales

Lagging Index

1. Average duration of unemployment

2. Inventories to sales ratio, manufacturing and trade

3. Labor cost per unit of output, manufacturing

4. Average prime rate

5. Commercial and industrial loans

6. Consumer installment credit to personal income ratio

7. Consumer price index for services

5-1b Monitoring Indicators of Inflation

The Fed closely monitors price indexes and other indicators to assess the U.S. inflation rate.

Producer and Consumer Price Indexes The producer price index represents prices at the wholesale level, and the consumer price index represents prices paid by consumers (retail level). There is a lag time of about one month after the period being measured due to the time required to compile price information for the indexes. Nevertheless, financial markets closely monitor the price indexes because they may be used to forecast inflation, which affects nominal interest rates and the prices of some securities. Agricultural price indexes reflect recent price movements in grains, fruits, and vegetables. Housing price indexes reflect recent price movements in homes and rental properties.

Other Inflation Indicators In addition to price indexes, there are several other indicators of inflation. Wage rates are periodically reported in various regions of the United States. Because wages and prices are highly correlated over the long run, wages can indicate price movements. Oil prices can signal future inflation because they affect the costs of some forms of production as well as transportation costs and the prices paid by consumers for gasoline.

   The price of gold is closely monitored because gold prices tend to move in tandem with inflation. Some investors buy gold as a hedge against future inflation. Therefore, a rise in gold prices may signal the market's expectation that inflation will increase.

   Indicators of economic growth might also be used to indicate inflation. For example, the release of several favorable employment reports may arouse concern that the economy will overheat and lead to demand-pull inflation , which occurs when excessive spending pulls up prices. Although these reports offer favorable information about economic growth, their information about inflation is unfavorable. The financial markets can be adversely affected by such reports, because investors anticipate that the Fed will have to increase interest rates in order to reduce the inflationary momentum.

5-2 IMPLEMENTING MONETARY POLICY

The Federal Open Market Committee assesses economic conditions, and identifies its main concerns about the economy to determine the monetary policy that would alleviate its concerns. Its monetary policy changes the money supply in order to influence interest rates, which affect the level of aggregate borrowing and spending by households and firms. The level of aggregate spending affects demand for products and services, and therefore affects both price levels (inflation) and the unemployment level.

5-2a Effects of a Stimulative Monetary Policy

The effects of a stimulative monetary policy can be illustrated using the loanable funds framework described in Chapter 2 . Recall that the interaction between the supply of loanable funds and the demand for loanable funds determines the interest rate charged on such funds. Much of the demand for loanable funds is by households, firms, and government agencies that need to borrow money. Recall that the demand curve indicates the quantity of funds that would be demanded (at that time) at various possible interest rates. This curve is downward sloping because many potential borrowers would borrow a larger quantity of funds at lower interest rates.

   The supply curve of loanable funds indicates the quantity of funds that would be supplied (at that time) at various possible interest rates. This curve is upward sloping because suppliers of funds tend to supply a larger amount of funds when the interest rate is higher. Assume that, as of today, the demand and supply curves for loanable funds are those labeled D1 and S1 (respectively) in the left graph of Exhibit 5.2 . This plot reveals that the equilibrium interest rate is i1. The right graph of Exhibit 5.2 depicts the typical relationship between the interest rate on loanable funds and the current level of business investment. The relation is inverse because firms are more willing to expand when interest rates are relatively low. Given an equilibrium interest rate of i1, the level of business investment is B1.

Exhibit 5.2 Effects of an Increased Money Supply

   With a stimulative monetary policy, the Fed increases the supply of funds in the banking system, which can increase the level of business investment, and hence aggregate spending in the economy.

   The Fed purchases Treasury securities in the secondary market. As the investors who sell their Treasury securities receive payment from the Fed, their account balances at financial institutions increase without any offsetting decrease in the account balances of any other financial institutions. Thus there is a net increase in the total supply of loanable funds in the banking system.

Impact on Interest Rates If the Fed's action results in an increase of $5 billion in loanable funds, then the quantity of loanable funds supplied will now be $5 billion higher at any possible interest rate level. This means that the supply curve for loanable funds shifts outward to S2 in Exhibit 5.2 . The difference between S2 and S1 is that S2 incorporates the $5 billion of loanable funds added as a result of the Fed's actions.

   Given the shift in the supply curve for loanable funds, the quantity of loanable funds supplied exceeds the quantity of loanable funds demanded at the interest rate level i1. The interest rate will therefore decline to i2, the level at which the quantities of loanable funds supplied and demanded are equal.

Logic Behind the Impact on Interest Rates The graphic effects are supplemented here with a logical explanation for why the interest rates decline in response to the monetary policy. When depository institutions experience an increase in supply of funds due to the Fed's stimulative monetary policy, they have more funds than they need at prevailing interest rates. Those depository institutions that commonly obtain very short-term loans (such as one day) in the so-called federal funds may not need to borrow as many funds. Those depository institutions that commonly lend to others in this market may be more willing to accept a lower interest rate (called the federal funds rate) when providing short-term loans in this market. The federal funds rate is directly affected by changes to the supply of money in the banking system. The Fed's monetary policy is commonly intended to alter the supply of funds in the banking system in order to achieve a specific targeted federal funds rate, such as reducing that rate from 3 to 2.75 percent or to a value within the range from 2.75 to 3 percent.

   The Fed's monetary policy actions not only have a direct effect on the federal funds rate, but also affect the Treasury yield (or rate). When the Fed purchases a large amount of Treasury securities, it raises the price of Treasury securities, and therefore lowers the yield (or rate) to be earned by any investors who invest in Treasury securities at the higher prevailing price.

   Most importantly, the impact of the Fed's stimulative monetary policy indirectly affects other interest rates as well, including loan rates paid by businesses. The lower interest rate level causes an increase in the level of business investment from B1 to B2. That is, businesses are willing to pursue additional projects now that their cost of financing is lower. The increase in business investment represents new business spending triggered by lower interest rates, which reduced the corporate cost of financing new projects.

Logic Behind the Effects on Business Cost of Debt Depository institutions are willing to charge a lower loan rate in response to the stimulative monetary policy, since their cost of funds (based on the rate they pay on deposits) is now lower. The institutions also reduce their rates on loans in order to attract more potential borrowers to make use of the newly available funds.

   Another way to understand the effects of a stimulative monetary policy on the business cost of debt is to consider the influence of the risk-free rate on all interest rates. Recall from Chapter 3 that the yield for a security with a particular maturity is primarily based on the risk-free rate (the Treasury rate) for that same maturity plus a credit risk premium. Thus the financing rate on a business loan is based on the risk-free rate plus a premium that reflects the credit risk of the business that is borrowing the money. So if the prevailing Treasury (risk-free) security rate is 5 percent on an annualized basis, a business has a low level of risk that pays a 3 percent credit risk premium when borrowing money would be able to obtain funds at 8 percent (5 percent risk-free rate plus 3 percent credit risk premium). However, if the Fed implements a stimulative monetary policy that reduces the Treasury security rate to 4 percent, the business would be able to borrow funds at 7 percent (4 percent risk-free rate plus 3 percent credit risk premium).

   Businesses with other degrees of credit risk will also be affected by the Fed's monetary policy. Consider a business with moderate risk that pays a credit premium of 4 percent above the risk-free rate to obtain funds. When the Treasury (risk-free) rate was 5 percent, this business would be able to borrow funds at 9 percent (5 percent risk-free rate plus 4 percent credit risk premium). However, if the Fed implements a stimulative monetary policy that reduces the Treasury security rate to 4 percent, the business would be able to borrow funds at 8 percent (4 percent risk-free rate plus 4 percent credit risk premium).

   The point here is that all businesses (regardless of their risk level) will be able to borrow funds at lower rates as a result of the Fed's stimulative monetary policy. Therefore, when they consider possible projects such as expanding their product line or building a new facility, they may be more willing to implement some projects as a result of the lower cost of funds. As firms implement more projects, they spend more money, and that extra spending results in higher income to individuals or other firms who receive the proceeds. They may also hire more employees in order to expand their businesses. This generates more income for those new employees, who will spend some of their new income, and that spending provides income to the individuals or firms who receive the proceeds.

Effects on Business Cost of Equity Many businesses also rely on equity as another key source of capital. Monetary policy can also influence the cost of equity. The cost of a firm's equity is based on the risk-free rate, plus a risk premium that reflects the sensitivity of the firm's stock price movements to general stock market movements. This concept is discussed in more detail in Chapter 11 , but the main point for now is that the firm's cost of equity is positively related to the risk-free rate. Therefore, if the Fed can reduce the risk-free by 1 percent, it can reduce a firm's cost of equity by 1 percent.

Summary of Effects In summary, the Fed's ability to stimulate the economy are due to its effects on the Treasury (risk-free) rate, which influences the cost of debt and the cost of equity in Exhibit 5.3 . As the Fed reduces the risk-free rate, it reduces the firm's cost of borrowing (debt) and the firm's cost of equity, and therefore reduces the firm's cost of capital. If a firm's cost of capital is reduced, its required return on potential projects is reduced. Thus, more of the possible projects that a firm considers will be judged as feasible and will be implemented. As firms in the U.S. implement more projects that they now believe are feasible, they increase their spending, and this can stimulate the economy and create jobs.

   Notice that for the Fed to stimulate the economy and create more jobs, it is not using its money to purchase products. It is not telling firms that they must hire more employees. Instead, its stimulative monetary policy reduces the cost of funds, which encourages firms to spend more money. In a similar manner, the Fed's stimulative monetary policy can reduce the cost of borrowing for households as well. As with firms, their cost of borrowing is based on the prevailing risk-free rate plus a credit risk premium. When the Fed's stimulative monetary policy results in a lower Treasury (risk-free) rate, it lowers the cost of borrowing for households, which encourages households to spend more money. As firms and households increase their spending, they stimulate the economy and create jobs.

Exhibit 5.3 How the Fed Can Stimulate the Economy

5-2b Fed's Policy Focuses on Long-term Maturities

Yields on Treasury securities can vary among maturities. If the yield curve (discussed in Chapter 3 ) is upward sloping, this implies that longer-term Treasury securities have higher annualized yields than shorter-term Treasury securities. The Fed had already been able to reduce short-term Treasury rates to near zero with its stimulative monetary policy over the 2010–2012 period. However, this did not have much impact on the firms that borrow at long-term fixed interest rates. These borrowers incur a cost of debt that is highly influenced by the long-term Treasury rates, not the short-term Treasury rates.

   To the extent that the Fed wants to encourage businesses to increase their spending on long-term projects, it may need to use a stimulative policy that is focused on reducing the long-term Treasury yields, which would reduce the long-term debt rates. So if the Fed wants to reduce the rate that these potential borrowers would pay for fixed-rate loans with 10-year maturities, it would attempt to use a monetary policy that reduces the yield on Treasury securities with 10-year maturities (which reflects the 10-year risk-free rate).

   In some periods, the Fed has directed its monetary policy at the trading of Treasury securities with specific maturities so that it can cause a bigger change for some maturities than others. In 2011 and 2012, the Fed periodically implemented an “operation twist” strategy (which it also implemented in 1961). It sold some holdings of short-term Treasury securities, and used the proceeds to purchase long-term Treasury securities. In theory, the strategy would increase short-term interest rates and reduce long-term interest rates, which would reflect a twist of the yield curve.

   The logic behind the strategy is that the Fed should focus on reducing long-term interest rates rather than short-term interest rates in order to encourage firms to borrow and spend more funds. Since firms should be more willing to increase their spending on new projects when long-term interests are reduced, the strategy could help stimulate the economy and create jobs. In addition, potential home buyers might be more willing to purchase homes if long-term interest rates were lower. However, there is not complete agreement on whether this strategy would really have a substantial and sustained effect on long-term interest rates. Money flows between short-term and long-term Treasury markets, which means that it is difficult for the Fed to have one type of impact in the long-term market that is different from that in the short-term market. The operation twist strategy was able to reduce long-term Treasury rates, but its total impact may have been limited for other reasons explained later in this chapter.

5-2c Why a Stimulative Monetary Policy Might Fail

While a stimulative monetary policy is normally desirable when the economy is weak, it is not always effective, for the reasons provided next.

Limited Credit Provided by Banks The ability of the Fed to stimulate the economy is partially influenced by the willingness of depository institutions to lend funds. Even if the Fed increases the level of bank funds during a weak economy, banks may be unwilling to extend credit to some potential borrowers; the result is a credit crunch.

   Banks provide loans only after confirming that the borrower's future cash flows will be adequate to make loan repayments. In a weak economy, the future cash flows of many potential borrowers are more uncertain, causing a reduction in loan applications (demand for loans) and in the number of loan applicants that meet a bank's qualification standards.

   Banks and other lending institutions have a responsibility to their depositors, shareholders, and regulators to avoid loans that are likely to default. Because default risk rises during a weak economy, some potential borrowers will be unable to obtain loans. Others may qualify only if they pay high risk premiums to cover their default risk. Thus the effects of the Fed's monetary policy may be limited if potential borrowers do not qualify or are unwilling to incur the high-risk premiums. If banks do not lend out the additional funds that have been pumped into the banking system by the Fed, the economy will not be stimulated.

EXAMPLE

During the credit crisis that began in 2008, the Fed attempted to stimulate the economy by using monetary policy to reduce interest rates. Initially, however, the effect of the monetary policy was negligible. Firms were unwilling to borrow even at low interest rates because they did not want to expand while economic conditions were so weak. In addition, commercial banks raised the standards necessary to qualify for loans so that they would not repeat any of the mistakes (such as liberal lending standards) that led to the credit crisis. Consequently, the amount of new loans resulting from the Fed's stimulative monetary policy was limited, and therefore the amount of new spending was limited as well.

Low Return on Savings Although the Fed's policy of reducing interest rates allows for lower borrowing rates, it also results in lower returns on savings. The interest rates on bank deposits are close to zero, which limits the potential returns that can be earned by investors who want to save money. This might encourage individuals to borrow (and spend) rather than save, which could allow for a greater stimulative effect on the economy. However, some individuals that are encouraged to borrow because of lower interest rates may not be able to repay their debt. Therefore, the very low interest rates might lead to more personal bankruptcies.

   Furthermore, some savers, such as retirees, rely heavily on their interest income to cover their periodic expenses. When interest rates are close to zero, interest income is close to zero, and retirees that rely on interest income have to restrict their spending. This effect can partially offset the expected stimulative effect of lower interest rates. Some retirees may decide to invest their money in alternative ways (such as in stocks) instead of as bank deposits when interest rates are low. However, many alternative investments are risky, and could cause retirees to experience losses on their retirement funds.

Adverse Effects on Inflation When a stimulative monetary policy is used, the increase in money supply growth may cause an increase in inflationary expectations, which may limit the impact on interest rates.

EXAMPLE

Assume that the U.S. economy is very weak, and suppose the Fed responds by using open market operations (purchasing Treasury securities) to increase the supply of loanable funds. This action is supposed to reduce interest rates and increase the level of borrowing and spending. However, there is some evidence that high money growth may also lead to higher inflation over time. To the extent that businesses and households recognize that an increase in money growth will cause higher inflation, they will revise their inflationary expectations upward as a result. This effect is often referred to as the theory of rational expectations. Higher inflationary expectations encourage businesses and households to increase their demand for loanable funds (as explained in Chapter 2) in order to borrow and make planned expenditures before price levels increase. This increase in demand reflects a rush to make planned purchases now.

   These effects of the Fed's monetary policy are shown in Exhibit 5.4 . The result is an increase in both the supply of loanable funds and the demand for those funds. The effects are offsetting, so the Fed may not be able to reduce interest rates for a sustained period of time. If the Fed cannot force interest rates lower with an active monetary policy, it will be unable to stimulate an increase in the level of business investment. Business investment will increase only if the cost of financing is reduced, making some proposed business projects feasible. If the increase in business investment does not occur, economic conditions will not improve.

Exhibit 5.4 Effects of an Increased Money Supply According to Rational Expectations Theory

   Because the effects of a stimulative policy could be disrupted by expected inflation, an alternative approach is a passive monetary policy that allows the economy to correct itself rather than rely on the Fed's intervention. Interest rates should ultimately decline in a weak economy even without a stimulative monetary policy because the demand for loanable funds should decline as economic growth weakens. In this case, interest rates would decline without a corresponding increase in inflationary expectations, so the interest rates may stay lower for a sustained period of time. Consequently, the level of business investment should ultimately increase, which should lead to a stronger economy and more jobs.

   The major criticism of a passive monetary policy is that the weak economy could take years to correct itself. During a slow economy, interest rates might not decrease until a year later if the Fed played a passive role and did not intervene to stimulate the economy. Most people would probably prefer that the Fed take an active role in improving economic conditions—rather than take a passive role and simply hope that the economy will correct itself.

   Even if the Fed's stimulative policy does not affect inflation and if banks are willing to lend the funds received, it is possible that firms and businesses will not be willing to borrow more money. Some firms may have already reached their debt capacity, so that they are restricted from borrowing more money, even if loan rates are reduced. They may believe that any additional debt could increase the likelihood of bankruptcy. Thus they may delay their spending until the economy has improved.

   Similarly, households that commonly borrow to purchase vehicles, homes, and other products may also prefer to avoid borrowing more money during weak economies, even if interest rates are low. Households who are unemployed are not in a position to borrow more money. And even if employed households can obtain loans from financial institutions, they may believe that they are already at their debt capacity. The economic conditions might make them worry that their job is not stable, and they prefer not to increase their debt until their economic conditions improve and their job is more secure.

   So while the Fed hopes that the lower interest rates will encourage more borrowing and spending to stimulate the economy, the potential spenders (firms and households) may delay their borrowing until the economy improves. But the economy may not improve unless firms and households increase their spending. While the Fed can lower interest rates, it cannot necessarily force firms or households to borrow more money. If the firms and households do not borrow more money, they will not be able to spend more money.

   One related concern about the Fed's stimulative monetary policy is that if it is successful in encouraging firms and households to borrow funds, it might indirectly cause some of them to borrow beyond what they can afford to borrow. Thus it might ultimately result in more bankruptcies and cause a new phase of economic problems.

5-2d Effects of Restrictive Monetary Policy

If excessive inflation is the Fed's main concern, then the Fed can implement a restrictive (tight-money) policy by using open market operations to reduce money supply growth. A portion of the inflation may be due to demand-pull inflation, which the Fed can reduce by slowing economic growth and thereby the excessive spending that can lead to this type of inflation.

   To slow economic growth and reduce inflationary pressures, the Fed can sell some of its holdings of Treasury securities in the secondary market. As investors make payments to purchase these Treasury securities, their account balances decrease without any offsetting increase in the account balances of any other financial institutions. Thus there is a net decrease in deposit accounts (money), which results in a net decrease in the quantity of loanable funds.

   Assume that the Fed's action causes a decrease of $5 billion in loanable funds. The quantity of loanable funds supplied will now be $5 billion lower at any possible interest rate level. This reflects an inward shift in the supply curve from S1 to S2, as shown in Exhibit 5.5 .

   Given the inward shift in the supply curve for loanable funds, the quantity of loanable funds demanded exceeds the quantity of loanable funds supplied at the original interest rate level (i1). Thus the interest rate will increase to i2, the level at which the quantities of loanable funds supplied and demanded are equal.

Exhibit 5.5 Effects of a Reduced Money Supply

   Depository institutions raise not only the rate charged on loans in the federal funds market but also the interest rates on deposits and on household and business loans. If the Fed's restrictive monetary policy increases the Treasury rate from 5 to 6 percent, a firm that must pay a risk premium of 4 percent must now pay 10 percent (6 percent risk-free rate plus 4 percent credit risk premium) to borrow funds. All firms and households who consider borrowing money incur a higher cost of debt as a result of the Fed's restrictive monetary policy. The effect of the Fed's monetary policy on loans to households and businesses is important, since the Fed's ability to affect the amount of spending in the economy stems from influencing the rates charged on household and business loans.

   The higher interest rate level increases the corporate cost of financing new projects and therefore causes a decrease in the level of business investment from B1 to B2. As economic growth is slowed by this reduction in business investment, inflationary pressure may be reduced.

5-2e Summary of Monetary Policy Effects

Exhibit 5.6 summarizes how the Fed can affect economic conditions through its influence on the supply of loanable funds. The top part of the exhibit illustrates a stimulative (loose-money) monetary policy intended to boost economic growth, and the bottom part illustrates a restrictive (tight-money) monetary policy intended to reduce inflation.

Exhibit 5.6 How Monetary Policy Can Affect Economic Conditions

Lagged Effects of Monetary Policy There are three lags involved in monetary policy that can make the Fed's job more challenging. First, there is a recognition lag, or the lag between the time a problem arises and the time it is recognized. Most economic problems are initially revealed by statistics, not actual observation. Because economic statistics are reported only periodically, they will not immediately signal a problem. For example, the unemployment rate is reported monthly. A sudden increase in unemployment may not be detected until the end of the month, when statistics finally reveal the problem. Even if unemployment increases slightly each month for two straight months, the Fed might not act on this information because it may not seem significant. A few more months of steadily increasing unemployment, however, would force the Fed to recognize that a serious problem exists. In such a case, the recognition lag may be four months or longer.

   The lag from the time a serious problem is recognized until the time the Fed implements a policy to resolve that problem is known as the implementation lag . Then, even after the Fed implements a policy, there will be an impact lag until the policy has its full impact on the economy. For example, an adjustment in money supply growth may have an immediate impact on the economy to some degree, but its full impact may not occur until a year or so after the adjustment.

   These lags hinder the Fed's control of the economy. Suppose the Fed uses a stimulative policy to stimulate the economy and reduce unemployment. By the time the implemented monetary policy begins to take effect, the unemployment rate may have already reversed itself and may now be trending downward as a result of some other outside factors (such as a weakened dollar that increased foreign demand for U.S. goods and created U.S. jobs). Without monetary policy lags, implemented policies would be more effective.

5-3 TRADE-OFF IN MONETARY POLICY

Ideally, the Fed would like to achieve both a very low level of unemployment and a very low level of inflation in the United States. The U.S. unemployment rate should be low in a period when U.S. economic conditions are strong. Inflation will likely be relatively high at this time, however, because wages and price levels tend to increase when economic conditions are strong. Conversely, inflation may be lower when economic conditions are weak, but unemployment will be relatively high. It is therefore difficult, if not impossible, for the Fed to cure both problems simultaneously.

   When inflation is higher than the Fed deems acceptable, it may consider implementing a restrictive (tight-money) policy to reduce economic growth. As economic growth slows, producers cannot as easily raise their prices and still maintain sales volume. Similarly, workers are less in demand and have less bargaining power on wages. Thus the use of a restrictive policy to slow economic growth can reduce the inflation rate. A possible cost of the lower inflation rate is higher unemployment. If the economy becomes stagnant because of the restrictive policy, sales may decrease, inventories may accumulate, and firms may reduce their workforces to reduce production.

   A stimulative policy can reduce unemployment whereas a restrictive policy can reduce inflation; the Fed must therefore determine whether unemployment or inflation is the more serious problem. It may not be able to solve both problems simultaneously. In fact, it may not be able to fully eliminate either problem. Although a stimulative policy can stimulate the economy, it does not guarantee that unskilled workers will be hired. Although a restrictive policy can reduce inflation caused by excessive spending, it cannot reduce inflation caused by such factors as an agreement by members of an oil cartel to maintain high oil prices.

Exhibit 5.7 Trade-off between Reducing Inflation and Unemployment

5-3a Impact of Other Forces on the Trade-off

Other forces may also affect the trade-off faced by the Fed. Consider a situation where, because of specific cost factors (e.g., an increase in energy costs), inflation will be at least 3 percent. In other words, this much inflation will exist no matter what type of monetary policy the Fed implements. Assume that, because of the number of unskilled workers and people “between jobs,” the unemployment rate will be at least 4 percent. A stimulative policy will stimulate the economy sufficiently to maintain unemployment at that minimum level of 4 percent. However, such a stimulative policy may also cause additional inflation beyond the 3 percent level. Conversely, a restrictive policy could maintain inflation at the 3 percent minimum, but unemployment would likely rise above the 4 percent minimum.

   This trade-off is illustrated in Exhibit 5.7 . Here the Fed can use a very stimulative (loose-money) policy that is expected to result in point A (9 percent inflation and 4 percent unemployment), or it can use a highly restrictive (tight-money) policy that is expected to result in point B (3 percent inflation and 8 percent unemployment). Alternatively, it can implement a compromise policy that will result in some point along the curve between A and B.

   Historical data on annual inflation and unemployment rates show that when one of these problems worsens, the other does not automatically improve. Both variables can rise or fall simultaneously over time. Nevertheless, this does not refute the trade-off faced by the Fed. It simply means that some outside factors have affected inflation or unemployment or both.

EXAMPLE

Recall that the Fed could have achieved point A, point B, or somewhere along the curve connecting these two points during a particular time period. Now assume that oil prices have increased substantially such that the minimum inflation rate will be, say, 6 percent. In addition, assume that various training centers for unskilled workers have been closed, leaving a higher number of unskilled workers. This forces the minimum unemployment rate to 6 percent. Now the Fed's trade-off position has changed. The Fed's new set of possibilities is shown as curve CD in Exhibit 5.8 . Note that the points reflected on curve CD are not as desirable as the points along curve AB that were previously attainable. No matter what type of monetary policy the Fed uses, both the inflation rate and the unemployment rate will be higher than in the previous time period. This is not the Fed's fault.

Exhibit 5.8 Adjustment in the Trade-off between Unemployment and Inflation over Time

In fact, the Fed is still faced with a trade-off: between point C (11 percent inflation, 6 percent unemployment) and point D (6 percent inflation, 10 percent unemployment), or some other point along curve CD.

   For example, during the financial crisis of 2008-2009 and during 2010-2013 when the economy was still attempting to recover, the Fed focused more on reducing unemployment than on inflation. While it recognized that a stimulative monetary policy could increase inflation, it viewed inflation as the lesser of two evils. It would rather achieve a reduction in unemployment by stimulating the economy even if that resulted in a higher inflation rate.

   When FOMC members are primarily concerned with either inflation or unemployment, they tend to agree on the type of monetary policy that should be implemented. When both inflation and unemployment are relatively high, however, there is more disagreement among the members about the proper monetary policy to implement. Some members would likely argue for a restrictive policy to prevent inflation from rising, while other members would suggest that a