Understanding monetary stimulus’ effect on inflation and employment

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The Fed’s dual mandate

Through the Federal Reserve Act, Congress requires the U.S. Federal Reserve to make monetary policy so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates. Most economists believe that if the Fed achieved the first two mandates (maximum employment and stable prices), it would automatically achieve the third mandate (moderate long-term interest rates). So, monetary policymakers in the U.S. are usually described as having a dual mandate: to promote price stability and maximum employment.

The U.S. Federal Open Market Committee (or FOMC) meets eight times a year to decide on the level of monetary stimulus for the economy. The key objective of each of these meetings is to meet certain economic goals while adhering to the dual mandate.

dual mandate

Kocherlakota speaks in Michigan

While addressing his audience at the Economic Club of Marquette County, Michigan, on September 22, Minneapolis Fed President Narayana Kocherlakota noted that when the FOMC changes the level of stimulus, its actions tend to push inflation—the rate price growth—and employment in the same direction.

Raising the level of stimulus puts upward pressure on both inflation and employment. Lowering the level of stimulus puts downward pressure on both inflation and employment.

The relationship between monetary easing, inflation, and unemployment

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When interest rates go down (pursuant to monetary easing measures), it becomes cheaper to borrow. So households are more willing to buy goods and services and firms are in a better position to purchase items to expand their businesses, such as property and equipment. Firms respond to these increases in total (household and business) spending by hiring more workers and boosting production. So, when interest rates go down, the employment rate goes up.

Under the Fed’s monetary easing measures, when the Federal funds rate reduces along with QE measures, the resulting stronger demand for goods and services tends to push wages and other costs higher, reflecting the greater demand for workers and materials that are necessary for production. This, in turn, increases inflationary pressures in the economy.

Market impact

All else being equal, lower interest rates tend to raise equity prices as investors discount the future cash flows associated with equity investments at a lower rate. This is one of the reasons why exchange-traded funds such as the SPDR S&P 500 ETF (SPY), the Vanguard Total Stock Market ETF (VTI), and the SPDR Dow Jones Industrial Average ETF (DIA) gain when interest rates are low.

Major stock indices gain as increased production and sales improve profits, all else equal. Industrial firms like Cummins, Inc. (CMI) and General Motors (GM) are among those that stand to benefit.

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