All Eyes Are Now Set On The FED

All eyes are now set on the Federal Reserve. Market analysts are all interested in figuring out when the FED will increase the interest rate. The strong monthly jobs report brings the possibility of an interest rate hike into focus, while concerns about Greece and the euro zone continue to weigh.

A strong jobs data shows that the US economy is now recovering strongly from the financial crisis that it fell into a few years back. A strong recovery means US economy heating up soon which requires an increase in the interest rate by the FED to avoid the economy getting overheated.

Atlanta Fed President Dennis Lockhart on Friday said he thinks the U.S. economy continues to grow strongly enough to justify an initial interest rate hike later this year, but that weak inflation and wage growth were “worrisome.”

As always these decisions require a trade off. In this case there is a trade off between the jobs and inflation. At the heart of the challenge facing the Fed is a notion in economics that there is a short-run trade-off between unemployment and inflation. At some low rate of unemployment, the thinking goes, slack in the job market disappears; if unemployment goes below this point then wage and inflation pressures build as firms compete for a dwindling supply of workers.

Economists call this cutoff point a non-accelerating inflation rate of unemployment, or Nairu, and also point to a “natural rate” of unemployment where inflation is stable in the longer-run.

The problem is nobody knows the cutoff point. Economists merely estimate it.

The Federal Reserve will have to take the decision at some point in time. As you can see monetary policy is all guessing game. If you guessed it right, you are the winner. But if your guess is wide off the margin, it can hurt the economy. This is precisely what happened in 1938 when the FED had prematurely increased the interest rates and the economy again went into a tailspin.

The Federal Reserve controls the three tools of monetary policy–open market operations, the discount rate, and reserve requirements. The Board of Governors of the Federal Reserve System is responsible for the discount rate and reserve requirements, and the Federal Open Market Committee is responsible for open market operations. Using the three tools, the Federal Reserve influences the demand for, and supply of, balances that depository institutions hold at Federal Reserve Banks and in this way alters the federal funds rate. The federal funds rate is the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight.

This Federal Fund Rate determines the different interest rates in the economy both the short term and the long term. There is a lag between the setting of the Federal Fund Rate and the other interest rates in the economy. This lag can be a few months. So the changes in the monetary policy are not felt instantaneously throughout the economy rather these changes trickle through the economy with a lag of a few months.

0 Comments