James Bullard and the FOMC’s objective function
Claiming that the FOMC is closer to the goals its dual mandate prescribes, James Bullard shared a measured perspective at the Tennessee Bankers Association’s annual meeting in Palm Beach, Florida, on June 9, 2014. Bullard provided his audience with an objective function value chart that shows how near the FOMC is to its objectives of maximum employment and price stability.
The objective function value curve also highlights how the FOMC’s objective function value, which measures the FOMC’s distance from its goals, reacts to major macroeconomic events.
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Accordingly, the objective function value has heightened three times since 1960 on account of the oil crisis in 1973, the energy crisis in 1979, and the credit crisis in 2008. During economic crises, controlling macroeconomic variables such as unemployment and the inflation rate becomes difficult. Besides, these are among the first to be affected.
The oil crisis of 1973
The crisis started in October 1973, when the members of the Organization of Arab Petroleum Exporting Countries (or OAPEC) proclaimed an oil embargo. By the end of the embargo in March 1974, oil prices had risen from $3 per barrel to nearly $12. The oil crisis caused many global short-term and long-term economic and political effects.
The energy crisis of 1979
Also called “the second oil crisis” or “oil shock,” the crisis occurred due to decreased oil output in the wake of the Iranian Revolution. Despite the fact that global oil supply decreased by only ~4%, widespread panic resulted, driving the price far higher than supply justified, with the crude oil prices rising to $39.50 per barrel. As with the 1973 crisis, the global political and power balance was affected.
The subprime mortgage crisis
The credit crisis was a nationwide banking emergency that triggered the recession of 2008 through subprime mortgage delinquencies and foreclosures, resulting in the devaluation of the attendant securities. These mortgage-backed securities and collateralized debt obligations initially offered attractive rates of return due to the higher interest rates on the mortgages. However, the lower credit quality ultimately caused massive defaults. Several major financial institutions collapsed in September 2008, with significant disruption in the credit flow to businesses and consumers and the onset of a severe global recession.
Effects on investments
The credit crisis, which was a result of Americans with the poorest credit being leant money to purchase houses they couldn’t afford, affected the U.S. economy badly. Broad market ETFs like the SPDR S&P 500 (SPY) and the iShares S&P 100 (OEF), real estate ETFs like the Vanguard REIT Index ETF (VNQ), and banks like Citigroup Inc. (C) and Bank of America (BAC) all saw their prices slump.
Bullard went on to play with the objective function by taking the square root of the objective function values derived and plotting them to get a better scale for this measurement. Find out more in the next part of this series.