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The Federal Reserve Board: What it Is and Why it Matters

The Federal Reserve Board: What It Is, and Why It Matters CEPR Basic Economics Seminar Dean Baker November 3, 2005. The Federal Reserve Board: What it Is and Why it Matters. Unemployment and Poverty How the Fed Affects Unemployment The Non-Accelerating Inflation Rate of Unemployment (NAIRU)

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The Federal Reserve Board: What it Is and Why it Matters

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  1. The Federal Reserve Board:What It Is, and Why It MattersCEPR Basic Economics Seminar Dean BakerNovember 3, 2005

  2. The Federal Reserve Board: What it Is and Why it Matters • Unemployment and Poverty • How the Fed Affects Unemployment • The Non-Accelerating Inflation Rate of Unemployment (NAIRU) • Who Controls the Fed? • The European Central Bank and the European Welfare State

  3. Low Unemployment is the Best Anti-Poverty Measure

  4. Low Unemployment is the Best Anti-Poverty Measure • As the unemployment rate fell from over 7 percent to 4 percent, the poverty rate dropped from 15.1 percent to 11.3 percent. • The poverty rates for African Americans and Hispanics fell by almost 10 PP.

  5. Low Unemployment Disproportionately Benefits Blacks and Hispanics

  6. Low Unemployment Disproportionately Benefits Blacks and Hispanics • The unemployment rate for Blacks is typically twice the overall unemployment rate. • The unemployment rate for Hispanics is typically one and a half times the overall unemployment rate. • The unemployment rate for Black teens is typically six times the overall unemployment rate.

  7. Low Unemployment Disproportionately Benefits Lower Wage Workers

  8. Low Unemployment Disproportionately Benefits Lower Wage Workers • Wages for workers at the middle and bottom of the wage distribution stagnated from the eighties until the mid-nineties. • Workers at all points along the wage distribution experienced healthy wage growth during the years of relatively low unemployment from 1995-2000. • When the unemployment rate is low, workers can also push for better working condition and demand things like health care coverage and child care subsidies.

  9. How the Fed Affects the Unemployment Rate • The Fed controls the short-term interest rate – the federal funds rate (other tools include bank regulations and margin requirements for buying stock). • The short-term interest has some impact on business activity because it affects the cost of borrowing money to maintain business operations (higher costs, less business). • Higher short-term interest rates generally lead to higher long-term interest rates (car loans, mortgages, corporate bonds).

  10. How the Fed Affects the Unemployment Rate • Higher long-term rates reduce home building, consumer borrowing, and investment. • In general, higher short-term interest rates, mean higher long-term interest rates, which means slower growth and higher unemployment. • It is easier to slow the economy with high interest rates, than boost the economy with low interest rates.

  11. The Story of the Non-Accelerating Inflation Rate of Unemployment (NAIRU) • Common sense – lower unemployment rates, are associated with a stronger economy – other things equal, this should mean more inflationary pressure. • The NAIRU vs. common sense – according to the NAIRU theory, there is a level of unemployment, where the inflationary rate will stay fixed through time. If the unemployment rate is higher than NAIRU, then inflation falls. If the unemployment rate is lower than NAIRU, then inflation rises. • There is no widely accepted theoretical basis for the NAIRU – in other words, there is no generally accepted view as to why such a level of unemployment would exist.

  12. The Story of the Non-Accelerating Inflation Rate of Unemployment (NAIRU) • Statistical evidence gave a reasonably good fit for a NAIRU of 6.0 percent in the United States prior to 1994. • The vast majority of mainstream economists believed in a 6.0 percent NAIRU prior to 1994.

  13. The Importance of a 6.0 Percent NAIRU • No one wants continually accelerating inflation – 2 percent inflation rises to 3 percent, then to 5 percent, then to 10 percent, and pretty soon we have hyperinflation and the currency becomes worthless. • The NAIRU was used as an argument for raising interest rates and keeping the unemployment rate from falling in the late eighties and again in 1994. • Greenspan raised the short-term interest from 3.0 percent in February of 1994 to 6.0 percent in March of 1995. • If the Fed does not want the unemployment to fall, it can keep the unemployment rate from falling.

  14. The Greenspan Moment • In the summer of 1995, the economy was slowing, but the unemployment rate was still under 6.0 percent (i.e. below NAIRU) Greenspan lowered the interest rate. • The economy picked up and the unemployment rate began to fall, dropping below 5.0 percent in 1997, and eventually falling to 4.0 percent in 2000. • There was huge opposition within the economics profession to Greenspan’s decision to allow the unemployment rate to fall (including from Clinton’s appointees to the Fed).

  15. The Greenspan Moment • Greenspan (and the non-mainstream economists) was right – there was virtually no acceleration in the inflation rate over the six years from 1994 to 2000 when the unemployment rate was below the standard measures of NAIRU. • If Greenspan would have listened to the conventional economists, the unemployment rate never would have fallen much below 6.0 percent and we never would have gotten the enormous gains in wage growth and poverty reduction associated with lower unemployment.

  16. Who Runs the Fed? • The Open Market Committee – 7 Fed governors (appointed by the president) + 5 regional bank presidents. • The 12 Regional Fed Banks – controlled largely by bankers, but with opportunities for democratic input. • The Law Governing the Fed – the Humphrey-Hawkins Full Employment Act requires the Fed to pursue price stability and full employment (defined as 4.0 percent unemployment).

  17. The Politics of the Fed • Answering to financial markets – failing on inflation gets you in trouble, failing on unemployment doesn’t. • The public is very poorly informed about what the Fed does and how it affects them. • No one understands NAIRU and its policy implications – that an agency of the government (the Fed) would deliberately raise the unemployment rate.

  18. The Politics of the Fed • Deciding between the costs of higher unemployment and risks of higher inflation is a political decision – different people bear these costs. • The financial sector is very scared of having public debates over Fed policy. They use euphemisms to avoid having a public discussion of the actual policy (e.g. raising interest rates to keep the economy from overheating). • The mid-nineties debate over the NAIRU (insofar as it existed) was over growth rates – NOT levels of unemployment.

  19. The European Central Bank (ECB) and the European Welfare State • The ECB has the sole goal of maintaining price stability defined as keeping inflation under 2.0 percent. • The ECB has generally maintained a far more contractionary monetary policy than the Fed. • Virtually all economists would agree that if Greenspan’s monetary policy had been as contractionary as the policy followed by the ECB, growth in the United States would have been lower and unemployment would be higher.

  20. The European Central Bank (ECB) and the European Welfare State It is reasonable to believe that the contractionary monetary policy of the ECB has been an important factor in high European unemployment. If ECB policies raise the unemployment rate, then they also put more strains on the welfare state. Higher unemployment and slower growth raise government expenditures (e.g. unemployment insurance) and reduce tax revenue, thereby increasing the size of the government deficit. The ECB is largely protected against democratic input.

  21. Conclusion – Know What the Fed is Doing to You! • The level of the unemployment rate has an enormous impact on the well-being of most of the population – it swamps the impact of any politically feasible anti-poverty program. • The Fed can have a huge impact on the level of the unemployment rate – especially in keeping it high. • The Fed is not the market. • The public has a right to hold the Fed accountable for its performance.

  22. Reading List • Bernstein, J. and D. Baker, 2004. The Benefits of Full Employment, Washington, D.C.: The Economic Policy Institute. • Galbraith, J. 1998. Created Unequal: The Crisis In American Pay, New York: The Century Foundation. • Greider, W. 1987. Secrets of the Temple: How the Federal Reserve Board Runs the Country. New York: Simon and Schuster. • The Financial Markets Center [www.fmcenter.org].

  23. The Federal Reserve Board:What It Is, and Why It MattersDean Bakerbaker@cepr.netCenter for Economic and Policy Researchwww.cepr.net

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