How the Federal Reserve keeps the US economy from bonking

My buddy is training for his third Chicago Marathon. I’m preparing for a 10K mud-run.

He’s really fit and a family nurse practitioner, so I seek his advice on how to get in shape and what to eat. His advice usually focuses on pacing myself.

“You don’t want to push too far too fast – you’ll bonk for sure!”

Of course he’s right – you can push yourself while working out, but if you go a little too far too fast, you might end up on the pavement.

On the flip side, my bud asks me all types of questions about the economy. Last week he asked me a great question: “How much do you think the unemployment rate will go up if the Fed increases interest rates?”

The unemployment rate won’t go up, I told him, because the Federal Reserve isn’t going to make a policy change until it is convinced that the economy is running fast enough that it needs to be cooled down. In other words, the Fed is trying to make sure the economy won’t bonk!

Most economists still expect the Fed to raise rates next month; they feel that the economy needs to slow down so it doesn’t burn out. But calculating the “speed” of the economy is tricky; thus, pacing needs to be done judiciously.

So, what’s the Fed’s role, why does it care and what is it going to do?

The Fed: our lender of last resort

The Fed is the central bank of the United States, the lender of last resort (it doesn’t say “no” if a bank is in trouble and needs to cover its own deposits), and it establishes and monitors credit and oversees how money works its way around the economy.

Congress, when it wrote The Federal Reserve Act of 1913, declared that the Fed should engage in policy to ensure that unemployment and inflation aren’t too high and interest rates are stable. The act doesn’t, however, identify which of these three goals is primary, secondary or tertiary.

The Fed usually lets the economy and the preferences of its seven governors dictate which is most important. During the 2001 recession, for example, the Fed was very concerned with unemployment. As the economy started showing signs of declining corporate profitability and higher levels of inventory (a sign that people might lose their jobs), the Fed started pushing interest rates lower to give the economy a boost and keep unemployment low.

In 1980, however, the Fed saw that double-digit inflation rates were dragging the economy down. In this case, the Fed focused more on stable prices by targeting higher interest rates in order to rein in rising prices.

The Fed’s tool kit

The Fed has three primary tools to accomplish these goals: a) the discount rate, b) open market operations and c) reserve requirements.

Depending on how each tool is used, the economy has either more liquidity (money sloshing through the system) or less liquidity. If the Fed cuts discount rates, purchases government bonds from large banks or decreases reserve requirements (or how much a lender must deposit at the central bank), then it is engaging in expansionary monetary policy.

The goal of expansionary monetary policy is to increase economic activity and decrease the unemployment rate. These are the types of policies that the Fed has engaged in since a few years before the Great Recession began in 2008 by lowering the federal funds and discounts rates. (The federal funds rate is an interest rate charged by one bank to another bank while the discount rate is the interest charged by the Fed to a member bank. More on this later.) The graph below shows both rates from January 2005 through this past June:

Interest rates have been near zero for many years.Federal Reserve Bank of St. Louis

The Fed noticed the economy slowing and, to counteract this, targeted lower interest rates. These expansionary moves continued through the recession and settled at a low of 0.50% for the discount rate and 0.16%, effectively, for the federal funds rate.

Both of these rates are at or near the lower bound – they can’t get any lower than zero. That brings us to a fourth (unorthodox and rarely used) tool that the Fed has turned to: d) quantitative easing (QE). For QE, the Fed makes balance-sheet exchanges with large banks – the Fed exchanges money on its balance sheet for government securities on the bank’s balance sheet. This technique keeps liquidity up and interest rates low.

The cost of expansionary policies: inflation

But all these tools have a consequence, and one of them is inflation.

Inflation is primarily a monetary phenomenon – the more money consumers have the higher items will be priced. When a dozen hungry competitors on Survivor get US$100 to purchase food, pizza and cheeseburgers suddenly become more expensive. Similarly, when the Fed lowers rates, the economy will have more money and, usually, will experience an upward push in prices.

During the 2001 recession, the Fed reduced interest rates to get the economy moving again, eventually causing inflation to rise from 1% to 3% in 2004. As a result, the central bank reversed course and contracted the money supply by raising rates, which cooled growth and arguably kept inflation from increasing even more.

The graph shows how the Fed reacted to rising inflation mid-decade by cutting the Fed funds rate, thereby reducing inflation, as measured by the Consumer Price Index.Federal Reserve Bank of St. Louis

So, to return to my friend’s concern about what will happen when the Fed begins to lift interest rates again, how does this affect employment? The graph below shows, for example, that when the Fed began raising rates in 2004, the unemployment rate – which had been coming down thanks to the lower rates in effect since the recession – kept falling. Thus, when timed well, the central bank can keep the economy from overheating by raising rates without pushing up joblessness.

Even as the Fed raised rates beginning in 2004, unemployment kept coming down, until the global credit crisis hit a few years later.Federal Reserve Bank of St. Louis

Where is the economy now?

The most recent economic recession officially ended in June 2009. However, the economy hasn’t really returned to “business-as-usual” – the unemployment rate has fallen but at a slow pace (at the same time that the share of working-age Americans in the labor force has also declined).

So is the economy in a condition where the Fed should start contracting the money supply? There isn’t much inflation in the economy, as shown by the GDP deflator (shown below), the Consumer Price Index and the year-over-year change in the average hourly earnings of private employees. We use all three of these ways to measure inflation because each captures slightly different ways in which prices are fluctuating.

Inflation is hovering around 2%, below the Fed’s target, as measured by the GDP deflator.Federal Reserve Bank of St. Louis

All three of these inflation measures show inflation hovering around 2%. The Fed’s policy is loosely based on the Taylor Rule, which focuses on keeping inflation around 2%. Core inflation, as measured by the GDP deflator and the CPI, is below 2%, while wage inflation is finally starting to tick above 2%.

Does this mean the economy is in danger of bonking (overheating)?

That’s why Fed governors are taking the timing of raising its interest rate targets so seriously. Other measures, such as the duration of unemployment, suggest that wage inflation could indeed take off. The pool of employment candidates is getting smaller, and employers might have to offer higher wages to attract the best candidates.

Wage growth plunged during the recession and has since begun to gradually increase.Federal Reserve Bank of St. Louis

Of punch bowls and bonking: what does it mean?

William McChesney Martin, the chair of the Fed’s board of governors from 1951 to 1970, quipped that it was the role of the central bank to remove the punch bowl just as the party got going. But we’re not a nation of punch bowls. These days, we’re more like a nation of Fitbit wearers, tracking our steps and performance as we walk or run.

The economy has been chugging along, going from fast-paced steps to a medium-fast jog. Like a runner, we’ve moved into a groove where we’re sort of comfortable being slightly uncomfortable. We know the unemployment rate is falling but not fast enough, wages are gaining some momentum but barely outpacing inflation. The economy’s pace is not in obvious need of a coach’s intervention.

Except – to torture my analogy – the Fed’s view is that it has manipulated the wind so we’ve been running with a zephyr at our backs for a long time. There is no real doubt that the economy has legs and can do this on its own; the Fed sees this.

The Fed is probably going to make a move in the next few weeks, likely increasing the federal funds target by 50 basis points to about 0.5% and increasing the discount rate by the same amount. When it does, there will probably be a little movement in the equities markets but very little else. If the Fed were to make this move sooner (and without warning), there could be a significant uptick in activity.

The Fed’s view of this race differs from ours – we think we’re running a marathon, but the Fed knows it’s one of those crazy 100-mile-endurance-race-across-Death-Valley deals. It is the job of the Fed to slow us down just enough that we can keep racing.