The speech by the Cleveland Fed President Sandra Pianalto at the University of Dayton’s RISE forum in Ohio on March 26 highlighted her views on the evolution of the monetary policy since the beginning of 1930—the time Federal Reserve began conducting the “monetary policy.” The monetary policy is framed to control the supply of money and short-term interest rates to influence economic growth and inflation.
Sandra Pianalto took office on February 1, 2003, as the tenth chief executive of the Fourth District Federal Reserve Bank, at Cleveland. On August 8, 2013, Pianalto announced she would retire as the Cleveland Fed President “early next year.” Pianalto has long supported the Fed’s aggressive policies to lift the economy from recession and is seen as a centrist whose views reflect those of the Fed’s core decision makers.
Evolution of the monetary policy
The Federal Reserve has many responsibilities, which impact the socioeconomic welfare of the U.S. It wasn’t really until the 1930s that the Federal Reserve began conducting the monetary policy. During that decade, Congress established the Federal Open Market Committee, or FOMC, as the nation’s monetary policy making body. “With nearly more than 100 years of operation,the Federal Reserve’s objectives have been refined and updated over the decades,” said Pianatlo. She spoke about the transition of the Fed’s monetary policy from a conventional tool to more powerful unconventional tool, largely seen in the form of “quantitative easing (or QE) during the 2008 financial panic.” She also explained how the Fed targeted the Fed funds rate during the historical financial panics. Some of them are explained below.
Employment Act of 1946
At the conclusion of World War II with millions of soldiers returning home with no job prospects, Congress, under President Harry Truman, passed the employment act of 1946. The Federal reserve was given the responsibility to promote maximum employment, production, and purchasing power. Though, the act did not prescribe any specific actions, however, many economists including ones in the Federal Reserve, consistently aimed at low inflation typically ranged from 1% to 5% and a relatively strong labor market with annual unemployment rates at around 5%.
Nearly after three decades of growth immediately following the passage of the 1946 act, the U.S. experienced high inflation and unemployment, often referred to as “stagflation.” In early 1975, worsening economic conditions with unemployment rate as high as 8.5% and inflation above 10.0% encouraged Federal Reserve to keep the Fed funds rate low, which eventually translated in the lower long-term interest rates.
In 1978, Congress gave the FOMC an official mandate. The economy was reeling from energy price shocks, rising unemployment, and rapidly increasing inflation. In response, the Congress approved the Full Employment and Balanced Growth Act, often called the ‘Humphrey-Hawkins Act.” The act clearly entailed the Federal Reserve to “promote full employment” and “reasonable price stability,” the objectives that are known as the Fed’s dual mandate. The five-year objective was laid down that aimed at an unemployment rate not above 3% and an inflation rate equal to or less than 3%.
The Fed action and the markets
To achieve its objective, the Federal Reserve constantly increased the Fed funds rate during the 1978-1982 periods; however, it was not until 1983 that the inflation rate stabilized to 3% threshold from the whopping 14% in 1980. At the same time, the Fed’s monetary policy failed to control the unemployment rate, which peaked to 9.7% in 1983.
The Fed funds rate is the rate at which depository institutions lend to each other on an overnight basis. Other things being constant, an increase in the Fed’s funds rate decreases the liquidity in the market. In other words, the cost of borrowing becomes expensive, which eventually leads to a downfall in the demand and a decline in the corporate profits as prices of goods and services fall by a law of demand and supply.
Popular exchange-traded funds (or ETFs) like the SPDR S&P 500 ETF (SPY), the iShares Core S&P 500 ETF (IVV), and the iShares S&P 100 ETF (OEF), which track large-cap equities of companies like Apple (AAPL) and Exxon Mobil (XOM), react sharply to the change in interest rates.
© 2013 Market Realist, Inc.