Federal Reserve policymaking and macroeconomic indicators over thirty years

Macroeconomics

The two-year time period that will be covered in from the middle of 2002 to the middle of 2004. Starting with Q3 in 2002, the GDP figures during this time period were as follows:

Nominal

Real GDP

Trailing

GDP

(2009 chained)

change

This data shows that the economy was facing conditions of accelerating growth during this time period. The economy was improving relatively slowly during the latter stages of 2002 and into Q1 2003, but after that the growth began to accelerate. The trailing 12-months' growth rate was over 4% for Q4 2003 and the first half of 2004. Thus, the economy was in a period of robust growth, strong enough that there may have been inflationary pressures. The inflation rate during this period was as follows:

Y/Y

Y/Y

Jul-02

Jul-03

Aug-02

Aug-03

Oct-02

Oct-03

Nov-02

Nov-03

Dec-02

Dec-03

Jan-03

Jan-04

Feb-03

3%

Feb-04

1.70%

3%

1.70%

Apr-03

2.20%

Apr-04

2.30%

May-03

2.10%

May-04

3.10%

Jun-03

2.10%

Jun-04

3.30%

Source: BLS (2014)

These figures shows that during the period where GDP growth was relatively slow, the inflation rate was mostly within the bounds of what the Fed has targeted. Today it targets 2%, though that might not have been official policy back then. The key phrase, however, is over time. Nevertheless, with inflation over the Fed's target rate for a period of one full year from November 2002 to October 2003, and then back above in April 2004, the normal, expected policy response would be to increase interest rates in order to cool the economy. When inflation is too high, consumers lose their buying power, especially since wages are sticky. When consumers lose their buying power, this creates a net loss of wealth. Moreover, investors need to take greater risks to earn positive real returns, unless interest rates increase. So with a period of GDP growth and inflation above the Fed's target, the Federal Reserve should have guided monetary policy in a manner that was somewhat cautionary. This probably would have included a couple of small increases in the interest rate to cool inflationary pressure during the two-year period where inflation was above the 2% watermark, and perhaps another rate increase in the spring of 2004 when the inflation rate shot up rapidly. The Fed's response during this period, in terms of the target Fed funds rate, is as follows:

Fed Funds Rate, end of month

Jul-02

1.75%

Jul-03

1.00%

Aug-02

1.75%

Aug-03

1.00%

1.75%

1.00%

Oct-02

1.75%

Oct-03

1.00%

Nov-02

1.25%

Nov-03

1.00%

Dec-02

1.25%

Dec-03

1.00%

Jan-03

1.25%

Jan-04

1.00%

Feb-03

1.25%

Feb-04

1.00%

1.25%

1.00%

Apr-03

1.25%

Apr-04

1.00%

May-03

1.25%

May-04

1.00%

Jun-03

1.00%

Jun-04

1.25%

Source: New York Fed (2014)

What this shows is that the interest rates were cut when inflation started to rise. Rather than reversing course on this, the Fed cut rates further in June 2003. Through the rapid rise in inflation in early 2003 and persistently high inflation thereafter, interest rates were cut and then held low. The 1% rate constitutes expansionary monetary policy. The normal outcomes would be to see an increase in the GDP, a decrease in unemployment and an increase in inflation. We know that inflation was higher than normal during this period, and through this period the GDP was rising. With multiple months of inflation above the target -- albeit not by much -- and GDP that was rising over 4% per annum, the normal policy response would be to increase interest rates and constrain economic growth to levels that were less likely to result in high inflation.

So the Fed deviated from conventional monetary policy during this period. Given that it did not make much sense from the inflation and GDP perspectives, the unemployment rate must be examined. The Fed has a mandate to manage unemployment rate, inflation rate and GDP. The data shows that the unemployment rate during this period was unusually high. The rate was below 5% from the spring of 1997 to Sept, 2001, and after the terrorist attacks it spiked and was at 6% by December 2002. The unemployment rate is a lagging indicator, so some lag time was expected, but the rate remained persistently high during the mid-2002 to mid-2004 period. When the interest rate was cut to 1.25% in November, 2002, unemployment had been at 5.7% for several months, and was inching higher. When the rate was cut again in June 2003 to 1%, the unemployment rate had jumped to 6.3%. Thus, despite apparent strength elsewhere in the economy, the unemployment rate was continuing to increase during this period. The Fed saw some improvement in unemployment rates through early 2004, but these were probably not as strong as might have been expected given the economic strength. While inflation during most of this period was higher than the target, it is only when inflation ran significantly higher than the target for a couple of months in a row that the Fed finally started to increase rates.

This case highlights the importance of looking at all of the data, as well as understanding the mandate of the central bank. The Fed seeks to balance the economy. While it would like inflation to be low and GDP growth steady, this cannot come at the expense of jobs. What is evident from looking at the data is that the unemployment rate remained high after 9/11, even when the economy was otherwise well into a period of recovery. Thus, the Fed's monetary policy was not explicitly expansionary, at least not without cause. Critics have pointed to this period of low rates as a causal factor in the housing bubble that was beginning around this time, but the Fed was reacting to stubbornly high unemployment -- stuck at rates not seen in a decade -- and that is why the Fed funds rate remained lower than one might have expected during this period.