Mar 09 2008

Unemployment and inflation: understanding the Fed’s balancing act

Job losses worst in five years – Mar. 7, 2008

The news late last week out of Washington was not what the White House was hoping for only a couple of weeks after the passing of a fiscal stimulus package meant to achieve exactly the opposite of what has happened. The US Labor Department released its latest numbers on employment on Friday:

There was a net loss of 63,000 jobs, which is the biggest decline since March 2003 and weaker than the revised 22,000 jobs lost in January. Economists had forecast a gain of 25,000 jobs…

“Based on today’s Employment Report, if we are not in a recession, it is a darned good imitation of one,” said Kevin Giddis, managing director of fixed income at Morgan Keegan.

So with a net loss of jobs, it may seem weird to hear that unemployment has actually fallen from 4.9% to 4.8%. How is this possible? In this case lower unemployment may indicate an even worse reality for the American economy:

The unemployment rate fell because of an increase of 450,000 people whom the government no longer counts as being part of the labor force for a variety of factors, such as that they are not currently looking for work. That drop in the size of the labor force allowed for the modest decline in unemployment, even as the household survey showed 255,000 fewer Americans with jobs than in January.

Discouraged workers point to a deep pessimism underlying households and workers in America, indicating that if we’re not already in a recession, it is only a matter of time. With the apparent failure of fiscal policy at achieving any immediate turnaround in consumer confidence, all eye’s are now on the Fed, America’s central bank, to see how Ben Bernanke will respond to the latest round of bad news.

“Even the silver lining of a falling unemployment rate has a little rust,” said Rich Yamarone, director of economic research at Argus Research. He predicted that the central bank will cut rates by a half percentage point at both its March meeting and again on April 30.

But Yamarone and some other experts questioned whether additional Fed cuts would do much to improve the employment outlook.

“We’re not in a crisis because the cost of borrowing is too high, it’s because people are afraid of lending,” said Dan Alpert, managing director of Westwood Capital, referring to the ongoing credit crunch. “At the end of the day, the Fed cuts don’t really solve the problems. They’ve already cut allot; if jobs continue to decline in face of further interest rate cuts, it’s prima facie evidence cuts aren’t effective.”

But few experts were ready to suggest the Fed would stop cutting rates at this point, given the problems in the economy and financial markets.

“The Fed has to do what it can to provide remedy and not scare the market as well,” said Mike Materasso, a senior portfolio manager at Franklin Templeton.

Central bankers face difficult decisions in times like these. While unemployment and falling growth rates pose significant problems to the American economy, the third macroeconomic evil is certainly in the minds of policymakers when deciding how to deal with the first two: inflation.

In order to lower interest rates, the Fed first has to implement expansionary monetary policy. In other words, the central bank must increase America’s money supply. How does it do this, exactly? Most commonly, the Fed uses open market operations, which is a fancy way of saying the Fed buys and sells government securities (treasury notes, bonds, etc…) on the bond market. When the Fed wishes to lower interest rates, it must inject new money into the economy, which it does by buying government bonds from the holders of those securities; namely, the public.

American banks, households, and firms, as well as foreigners all hold government debt. When the Fed wants to expand the money supply, it simply starts buying these debt securities back from the public. The increase in demand for securities drives up their prices, encouraging holders of the debt to sell their securities to the Fed, for which they receive money in exchange. In effect, the public exchanges illiquid (unspendable) debt certificates for liquid money. Now consumers have more money in their pockets to spend, firms have more to invest, and banks have more to loan out to borrowers who want to spend and invest. How do banks get rid of their new liquidity? Yep, they lower their interest rates.

In a nutshell, that’s how monetary policy works. To combat a recession and rising unemployment, the Fed simply buys bonds on the open market, injecting liquidity into the economy, which should result in more borrowing and more spending, shifting aggregate demand out, leading to growth and rising employment.

But what about that third evil, inflation? Won’t more spending lead to demand pull inflation? Usually this is not a major concern in times of a slowdown, since rising unemployment indicates the economy is producing below its full employment level of output. Expanding aggregate demand should result in increased output and stable prices. Today, however, Americans are facing other inflationary pressures, including a historically weak dollar (meaning imported goods and raw materials are more expensive than ever), and skyrocketing food and energy prices due to rising global demand for such commodities.

This all makes the job of monetary policy exceptionally challenging for Mr. Bernanke and his colleagues at the Fed. Expand the money supply too much (i.e. lower interest rates too much) and you risk accellerating inflation. Keep rates too high, and we can expect even worse employment and output numbers in the next few months.

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9 responses so far

9 Responses to “Unemployment and inflation: understanding the Fed’s balancing act”

  1. Angel Liuon 11 Mar 2008 at 10:20 pm

    I wonder if an expansionary monetary policy an expansionary fiscal policy are similar in which the Fed can use all three tools of monetary policy: buying securities, lowering reserve ratio and discount rate. Thus it can avoid a great increase in interest rate and inflation. Because when the Fed lends loans money to commercial banks, it increases the money supply, which then decreases interest rate. Similarly, when commercial banks have more more excess reserves due to lower reserve rate, commercial banks can lend more money out and create an even greater money supply.

  2. Helenon 15 Mar 2008 at 2:50 am

    Relating this to the other blog post that I just read, the one about the impact on global inflation of American interest rate cuts, I am wondering if Mr. Bernanke takes into consideration the implications on the global economy when he makes decisions about monetary policy. I know he is trying to find the optimal "middle road" of monetary policy for America that will neither drive up inflation too much as a side effect nor exacerbate unemployment, but how big of a role does the global economy play when Mr. Bernanke makes a decision?

  3. Helenon 15 Mar 2008 at 2:55 am

    Relating this to the other blog post that I just read about, the one about the impact on global inflation of America's monetary policy, I am wondering if Bernanke takes into consideration the implications for the global economy when he makes a decision regarding monetary policy in America. I know the Fed is always trying to find the optimal "middle road" monetary policy for America that will neither induce excessive inflation as a side effect nor exacerbate the problem of unemployment, but how big of a role does the global economy play in this decision-making process? In other words, how much does the global economy weigh when the Fed is making decisions for the domestic economy?

  4. KatherineYangon 17 Mar 2008 at 8:22 pm

    The rising energy prices makes me wonder, if we'd just been more careful about the environment to begin with, just how much money would we be saving now? I'm talking about energy prices, the money spent on preserving what's left of the environment, no to mention the money spent on debating the whole environmental issue back and forth.

    Doesn't have much to do with the blog post…I was just wondering.

  5. claire425on 17 Mar 2008 at 8:30 pm

    Wow it is interesting that a lower unemployment rate does not necessarily means the economy is in a better state. It is always the main concern, when demand goes up, inflation goes up at the same time. Well,it is true that the governmetn is in hurry to fix the unemployment rate to a higher level, but in the long run, it is actually not that true. What if the net export due to the higher price level decreases, and weaken the value of dollars? It could actually result in a bigger loss. Therefore, agreeing to Helen's point that the government should find the "middle point", I just hope that by doing the calculations and estimating accurately, the government to find the upmost profitable point for the economy.

  6. Conrad Liuon 17 Mar 2008 at 9:41 pm

    Obviously, this drop in employment is not at all wanted in an economy in danger (or already in) of a recession. As we speak, if the Fed's have not yet taken steps large enough to impede this decrease in growth (or negative growth), there can be no doubt that the unemployment rate will go even lower; that is to say, the number of discouraged workers will increase, which causes the economy to go even lower in the full employment level that it already is.

  7. Charlie.Gaoon 18 Mar 2008 at 1:01 am

    Monetary policy, along with fiscal policy can be used together to bring economy back to full employment level. Inflation indeed is a problem therefore measures should be taken to improve it.

  8. Trevor Sunon 18 Mar 2008 at 10:40 pm

    I agree, monetary and fiscal policies could be used to fix the economy but is the U.S. government doing any of this? probably not…

  9. Tarynon 19 Mar 2008 at 11:39 am

    I honestly do not like the way unemployment in the US is counted. The numbers we see are not the "real" unemployment rate because it discounts discouraged workers, retired persons, people on sabbatical, etc. I think that the unemployment should count all of those people and then have several other numbers that show unemployment minus certain persons such as retired persons. I think then we would have a better understanding of unemployment and avoid the confusion between the unemployment rate and number.

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