Update on the Federal Reserve

This week the Federal Reserve has taken further unconventional action to attempt to stimulate the economy. In September the Fed announced it would buy bonds and other securities with newly created money to increase the money supply (more details here). With not much sign of things getting better yet, the Fed has expanded its asset purchasing (as in money creation) from $40 billion to $85 billion per month.

But that is only half the story. In September the Fed said it would continue making new money until unemployment falls back to "normal" levels, but only if inflation stays low. The limitations and thresholds were somewhat vague, which dulls the effect of the policy. However, this time, the Fed explicitly stated that it will continue creating money until unemployment goes below 7%, and keep interest rates near 0% until it goes below 6.5%. And even when it does they will not stop immediately, but rather gradually wind down the program. This is conditional on inflation staying near or below 2.5% in the short run[1]. The benefit of this policy is that the Fed is now committed in a clear manner to its stimulus. And as conditions change economic actors will know at what point the Fed policy will change.

I previously spoke of how large a change outlining policy in this manner is for the Fed. This is the first time ever the Fed has set an unemployment rate target[1]. Past efforts have involved set dollar amounts and calendar deadlines. Now the policy is still clear and predictable, but flexible and limited only by the accomplishment of its goals (you can find information on how monetary stimulus helps the economy here and here). I am a huge supporter of the Feds recent policy changes. While its no magic bullet and the magnitude of the effect is a matter of debate, it speaks well of our monetary institution that the Fed has been so able to adapt and act to economic conditions. 

My only present concern is the focus on keeping inflation near or below 2.5%[2]. I've posted about why inflation is not a threat in this weak economy here and here. We would not be hurt by inflation in the 3 - 4 % range, inflation has been that high numerous times in the past two decades. Keeping inflation relatively low will dull the stimulative effect because the Fed can only reduce inflation by slowing down the economy. The low inflation ceiling could lead people to expect that stimulus will be withdrawn too early. Metaphorically, the Fed is giving the economy more gas while still keeping a foot slightly on the breaks.




1. It's a big deal, trust me.

2. The most recent inflation figure, for November, has inflation at 1.8%, down from 2.2% in October.