Must-know: Why the Fed has trailed its inflation and job targets

Chicago Fed’s Dr. Charles Evans’ presentation in Istanbul

Chicago Fed president and chief executive officer (or CEO), Dr. Charles Evans, was the keynote speaker at the Macro Workshop, 2014 organized by the Central Bank of Turkey at the Istanbul School of Central Banking on June 2–3. The topic for the presentation was “A Perspective on Unconventional Monetary Policy.” In his presentation, Dr. Evans discussed the Fed’s dual mandate of achieving price stability and job creation.

Must-know: Why the Fed has trailed its inflation and job targets

The Fed has long-term targets of ensuring inflation at the 2% level and a sustainable unemployment level of between 5.2%–5.6%. Dr. Evans mentioned that the Fed should use a balanced approach to achieving its monetary policy goals (or “bull’s eye”), ensuring that deviations from long-run inflation and employment targets are minimized. He also mentioned several factors that made achieving these goals a lot harder:

  • Deleveraging in the aftermath of the financial crisis
  • Global risks
  • Unusually restrictive fiscal policy
  • Monetary policy that had been constrained by the Zero Lower Bound (or ZLB) in the Fed funds rate.

After the 2008 financial crisis, both households and businesses have gone through a prolonged period of declining debt levels. The housing crisis also drastically reduced the net worth for many families. These factors resulted in a fall in consumption. Consumption expenditure makes up about two-thirds of the economy. All else equal, a fall in consumption would reduce economic growth and vice-versa. Reduced consumption would also affect the revenues and profits of businesses, like companies in the S&P 500 Index (VOO).

Must-know: Why the Fed has trailed its inflation and job targets

Economic conditions in Europe and Asia were also affected by the financial crisis, which reduced demand for U.S. exports. Lower demand for U.S. products at home and abroad caused firms to reduce their debt levels. A prolonged period of corporate deleveraging would also reduce private investment in the economy and affect job creation. Fiscal spending cuts, along with the budget standoff in Washington, D.C. have also contributed to the slow pickup in economic growth and employment.

Must-know: Why the Fed has trailed its inflation and job targets

The Fed funds rate is the primary monetary policy tool for the Fed. The Fed can influence interest rate levels in the economy by changing the base rate. Changes to the base rate usually translate across bond (BND) markets, affecting Treasuries (TLT) as well as investment-grade (LQD) and high-yield (HYG) debt securities. When economic growth is flagging, central banks usually respond by decreasing the base rate, to stimulate borrowing and investment in the private sector. Due to the Fed rate at the ZLB since December, 2008, the Fed has been unable to make further use of this tool to provide monetary stimulus. This has been a key factor dampening job creation.

Ticker Index

VOO is the Vanguard S&P 500 ETF, which tracks the S&P 500 Index. TLT is the iShares 20+ Year Treasury Bond ETF. LQD is the iShares iBoxx $ Investment Grade Corporate Bond Fund. BND is the Vanguard Total Bond Market ETF. HYG is the iShares iBoxx $ High Yield Corporate Bond ETF.

In the next section of this series, we will discuss Dr. Evans’ take on the main policy tools available to the Fed, considering the ZLB constraints.