During 2008 at the height of the financial crisis, the Federal Government decided to reduce the interest rates for federal funds to the zero lower bound, which was the first time interest rates were lowered to such minimal rates. This was in the range of 0%-0.25%. Such a move was expected to restore the economy back to its feet, but unfortunately, this did not happen as the recovery process took longer than expected. For this reason, the Federal Government delayed on increasing the interest rates in the quest to await improvements in the economy. As an expansionary monetary policy, it was expected to stimulate expenditure in the economy (Angeloni & Faia, 2013). According to Ang and Longstaff (2013), after about seven years, the economy improved as the rate of employment was approaching its full capacity. At this juncture, the Fed started increasing the interest rates from December 16, 2015. This expansionary policy marked the beginning of slow-paced economic expansions. Previously, the Fed used to raise interest rates after shorter time periods as compared to what was happening. Before this, it had engaged in such policies twice. In both cases, after the end of an economic recession, it used to start raising the interest rates within three years. This later changed as the interest rates became raised at a slower pace in incremental steps to strengthen the monetary policy. In 2016, it increased the rates only once and in 2017 it did this thrice and every time raising them by 0.25%.
The Equilibrium Rate of Interest
Currently, the Fed engages in a less simulative policy. The long-term equilibrium interest rates now guide its moves. Whenever the rate of the Federal funds is below this rate, which acts as the neutral rate, the Fed will undertake expansionary measures to stimulate the economy. For a long time now, a comparison of the prevailing rate of inflation and the rate of the federal funds has consistently indicated that the later has continued to be lower. This means that the real interest rate of the funds is negative. The equilibrium rate is indicative of the state of the economy, and the Fed uses it as a guide for undertaking the right monetary policy. When the economy is slow and operates at a rate that is below full employment, the Fed stimulates economic growth by maintaining federal funds interest rates that are below the equilibrium rate. When the economy is operating at full employment, it maintains the rate that is equivalent to the neutral rate and keeps the rate above the equilibrium when the rate of inflation within the economy is high (Bruno & Shin, 2015).
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Caggiano, Castelnuovo and Groshenny (2014) argues that the monetary policy does not immediately affects the economy but takes some time before its impacts can be seen. The Federal Reserve is aware of this obstacle and tries to counteract it by adopting a forward strategy whereby it changes its monetary policy before the economy attains the expected status. This explains why it has been increasing the federal fund's interest rates gradually. It does this expecting that the economy is going to develop in such a manner that will justify this move. Consequently, these rates are expected to remain below the expected long-term interest rates continuously. It is a conscious path that the Federal Reserve undertakes and refers to it as "data dependent," entailing that the rate will only be revised if the actual level of inflation or employment becomes different from the projected forecasts.
Criticism of the Current Monetary Policy
Economists suggest that the achievements of the three economic goals of the monetary policy depend on the accurate assessment of the levels of employment as well as the rate of inflation (Dedola, Karadi & Lombardo, 2013). Further, according to Dedola and Lombardo (2013), the Fed, however, engages in preemptive decisions in setting the rate for federal funds which does not put into account the actual state of the economy but rather forecasts which are subject to deviations. Currently, it has set the target of 2% for the rate of inflation. Economists have disagreed on the way the Fed manages the current monetary policy to affect the economy.
Progress on the Federal Reserve Mandate
An analysis of the Fed’s dual mandate indicates that there has been significant progress in the promotion of employment. From 2015, unemployment rates have been between 4% to 5%. This is a significant achievement as it is lower than the long-term sustainable unemployment rate that the Fed projected. It has also established various labor measures that are supportive of full employment. However, the labor participation rate is still below the anticipated rate. Increase in the rate of employment or rather a decrease in the rate of unemployment was expected to lead to higher rates of inflation in the short-run according to economic theory. Contrarily, this has not been the case because inflation has stagnated over past recent years. Regarding price stability, there has been no much progress. Economic growth has been below 3%. Economic stimulus can only be effective if this stagnation is due to weak public expenditure. However, if it is caused by inherent weaknesses in growth within the economy, the stimulus will only lead to economic overheating (Hubrich & Tetlow, 2015).
Challenges faced by the Federal Reserve
The policy of the Fed to gradually increase interest rates at a slower pace imply that borrowing is cheap leading to greater spending and investments. Jorda, Schularick and Taylor (2015) argues that it poses the risk of high inflation leading to financial instability. A good example of such consequences is what happened during the housing bubble. On the other hand, if the rates are increased at a quicker pace, the Fed will have a greater opportunity of reducing the rates in the event of another economic recession leading to similar risks. The economy is currently near full employment. In 2017, the Fed engaged in aggressive tax cuts which stimulated the economy. This could have spillover effects that may increase inflation. A decrease in the interest rates by the Fed will provide a countering mechanism to prevent such from happening.
Unconventional Monetary Policy
During the 2008 financial crisis, the Fed was faced with the challenge of providing economic stimuli to boost the economy which was facing a downturn. The conventional monetary policy of lowering the Federal fund's interest rates was no longer effective as the rates were already at the zero lower bound. It thus resorted to Quantitative Easing (QE) which is unconventional monetary policy (Eggertsson, Ferrero & Raffo, 2014). It did this through large-scale asset purchases of United States agency mortgage-backed securities (MBS), Treasury bills and agency debts starting from 2009 to 2014. Henceforth, the monetary policy reverted to its normal practice. The QE resulted in the expansion of the Fed’s balance sheet by five times (Andrade & Le Bihan, 2013). It still maintains its balance sheet at the same size of $4.5 trillion. Instead of selling its assets to cut down this balance sheet size, it opts for raising the interest rates. In 2017, the Federal Reserve started to reduce its balance sheet by allowing some securities to “run off” after maturity as part of the normalization policy.
Conclusion
Monetary policy is one of the tools used by the government to control the state of its economy. It involves expansionary as well as deflationary policies to bring desirable effects to the economy. In the United States, the Federal Government derives its mandate to establish and affect the monetary policy of the Congress. The Federal government has the broad capacity to control the money supply as well as credit conditions within the economy. Conventional policy entails the manipulation of the interest rates to desired levels that will positively affect the economy. Unconventional policy involves large asset purchases, and it is resorted to when the use of interest rates is no longer effective.
References
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