Analysing the Federal Reserve Monetary Report: July 2021
By Patrick Savage, Yunjia Hu, Tim Doherty and Alex Campion
1.1 Labour Market Measures
The Fed uses multiple data to track the labour market such as unemployment rate, non-farm payrolls, manufacturing payrolls, labour-force participation rate, Automatic Data Processing (ADP) national employment report, and job opening and labour turning survey. Below is a more detailed analysis of different indicators.
Employment Situation Report, published monthly by the Bureau of Labour Statistics of the U.S. Department of Labour, generally covers two parts: household surveys and institutional surveys, which disclose employment-related data from various perspectives, including unemployment status, non-agricultural employment status, job gains and losses, average working hours of workers, and employment.
The household survey is based on telephone and letter interviews conducted by the government. The institutional survey directly consults enterprises about recent personnel changes.
The Fed looks at a range of indicators for the labour market but lays more emphasis on the unemployment rate as it is one of Fed’s dual mandates. On the 19th of June 2013, FOMC statement, chairman Bernanke stated that the 7% unemployment rate is indicative of the kind of progress we’d like to make in order to be able to say that we’ve reached substantial progress .
The most used unemployment rate is the U3 rate, which is the ratio of unemployed people (16 or older, actively searching for work) to the civilian labour force . The U-6 rate includes discouraged, underemployed, and unemployed workers in the country.
Below is a brief introduction of some of the other labour market indicators.
Non-farm payrolls measure the social, economic, and financial development of the United States. When the social economy is prosperous, consumption will naturally increase, and hence the number of jobs in consumer and service industries. This reflects a healthy economy, which in theory should be good for the exchange rate. If the data is good for a long time, US stocks and the US dollar will usually be supported and strengthened.
Labour-force participation rate is the number of people ages 16 and over who are employed or actively seeking employment divided by the total noninstitutionalized, civilian working-age population. This index can be used as a leading indicator of economic improvement and is regarded as a crucial factor in determining when the Federal Reserve will reduce the scale of quantitative easing (QE). In the 12 months ending in October 2021, the U.S. labour participation rate ranged between a low of 61.4% and a high of 61.7%, according to BLS .
The Fed collects these data as the labour market will influence the overall economy. For example, if unemployment is high, then demand for houses decreases, which influences the materials industry. Moreover, stocks may decrease as investors shift to safe-haven assets such as bonds. Government spending may increase due to more unemployment benefits. Hence, it is important for the Fed to ensure a healthy and stable economy.
1.2 Inflation Measures
Core PCE inflation stood at 4.6% in October 2021. This is markedly higher than the historic target of 2%, notwithstanding the fact that the Fed modified their target in 2020 to allow inflation to rise above this target for a time until the economy recovers. However, core PCE inflation is lower than headline CPI rate of inflation, which stood at 6.2% in October. This discrepancy can largely be explained by the fact that ‘core’ measures of inflation exclude more volatile goods such as food and energy, allowing the Fed to get a picture of the longer-term trend taking place. Although this helps the Fed to avoid getting caught up with short-term fluctuations, a common criticism is that because consumers are exposed to food and energy price inflation it makes the Fed blind to the problems they face.
The dramatic increase in inflation has made many headlines and has been attributed to many factors, notably:
- Supply-chain disruption stemming from lockdowns in response to COVID-19
- Unprecedented consumer demand as consumers rush to spend the savings they accumulated during lockdowns since March 2020
- Aggressively expansionary fiscal policy, amounting to some $5.6 trillion 
- An easy money policy facilitated by the Fed which comprised $4 trillion asset purchases 
- Short-term rises in the cost of energy
- Elevated unemployment benefits, which some have attributed to the tighter labour market
As you can see below, the Fed has performed well-judged by core PCE inflation since 1996, when the 2% inflation target was implicitly adopted by Fed officials [6 and 7].
The Fed focuses on inflation in order to assess whether it is fulfilling its objective of price stability. Elevated levels of inflation may lead to wage-price spirals as inflation expectations become un-anchored, necessitating painfully contractionary monetary policy. Low levels of inflation usually imply sluggish economic activity and typically encourage the Fed to lower interest rates in order to stimulate prices back towards its 2% target.
1.3 Inflation Expectations
The Fed takes two approaches to measuring inflation expectations: returns on financial instruments tied to inflation expectations and surveys of financial market participants, professional forecasters, households and businesses.
Returns on financial instruments reveal investors’ expectations for the variables that determine these returns, thus returns on financial instruments tied to inflation demonstrate expectations for inflation going forward. Such financial instruments broadly fall into one of two categories: Treasury Inflation Protected Securities (TIPS) and inflation swaps.
TIPS are Treasury Bonds indexed to inflation (as measured by the Consumer Price Index) such that they maintain their real value regardless of inflation. While TIPS alone can give insight into inflation uncertainty, comparing their yields to those of conventional Treasury securities illustrates market inflation expectations. The TIPS Breakeven Rate is the difference between the yields on conventional Treasury securities and TIPS, representing the difference between rate of return on nominal and inflation-indexed bonds. By no arbitrage, the real return on both types of bonds must be equal so we can infer that the difference between their yields, the TIPS Breakeven Rate, must be the expected rate of inflation. Obviously, this comparison requires that both bonds have the same maturities so comparing 5-year TIPS and 5-year conventional Treasury securities shows expected inflation over the next five years, comparing 10-year TIPS and 10-year conventional Treasury securities shows expected inflation over the next ten years, etc.
The second category of financial instruments analysed by the Fed are inflation swaps — an agreement between two counterparties to swap a notional principal amount for floating rate payments over a period, either in specified payments or in one lump sum at maturity. Say a business wants to hedge against inflation such that it has more certainty around its real cash flows into the future, then it may take an inflation swap in the amount of n at a specified swap rate r over a specified time period t such that it will receive n(1+r) ^t in fixed cash flows in total. The counterparty will receive a total floating cash flow from the business of n(1+pi(t)), the notional principal amount after inflation (as measured by the Consumer Price Index). For inflation swaps purposed only for businesses to hedge against inflation (i.e., there is no additional interest charged by counterparty), the final amounts will be as close as possible so:
At the start of the inflation swap, the counterparties clearly cannot know inflation over the time period they set the swap rate r, based on inflation expectations. There are a wide variety of inflation swaps over different time periods and different repayment frequencies, including:
- Zero-Coupon Swaps where there is only one cash flow at maturity
- Year-on-Year Swaps where a specified cash flow is exchanged each year
- Inflation swaps where some additional fee is charged by the counterparty
- Inflation swaps where the Fed can therefore deduce inflation expectations from the swap rates charged over various timeframes.
Finally, the Fed utilises a vast range of surveys on market participants, professional forecasters, households and businesses to estimate inflation expectations. These surveys are conducted by independent bodies, academic institutions and Federal Reserve Banks:
- Blue Chip Survey: survey of professional economists’ one-year Consumer Price Index expectations published monthly in Blue Chip Economic Indicators by independent Dutch information services form Wolters Kluwer
- The University of Michigan Surveys of Consumers: survey of household expectations for general prices over next 12 months
- Federal Reserve bank of New York Survey of Consumer Expectations: survey of 1,300 households in rotating panel for inflation one and three years into the future
- Consensus Economics: surveys professional forecaster inflation expectations
The Fed aggregates 21 collected data series on inflation expectations into a single index of Common Inflation Expectations (CIE). The index considers ‘short horizon’ inflation expectations for the coming year and ‘long horizon’ expectations for the subsequent 5–10 years through a variety of the different indicators described above. The CIE is used in subsequent modelling as a holistic measure of inflation expectations across the US economy.
Decision Making Processes
The FOMC meets to see whether the current economic status meets their expectation on the dual mandates. If not, then the Fed can use expansionary or tightening monetary policies through setting a target for the federal funds rate. This can further influence interest rates, asset prices and finally influence demand for goods and services when the transmission process is completed.
“Appropriate monetary policy” is defined as the future path of policy that each member of the FOMC deems most likely to foster outcomes for economic activity and inflation that best satisfies his or her individual interpretation of the statutory mandate to promote maximum employment and price stability . This gives considerably leeway to the Fed in adjusting its loss function in the way they feel best satisfies their dual-mandate, leaving it up to each member of the FOMC to decide whether to prioritise employment or prices.
Currently, the Fed is succeeding in maximising employment and seeing healthy economic growth however it would appear these have come at the expense of a higher rate of inflation.
The Fed expects inflation to be transitory because many of the factors currently driving inflation are short-term in nature, like the release of consumers’ lockdown savings and supply-chain bottlenecks. If this is the case, inflation will fall and policy won’t have to become contractionary, allowing the Fed to satisfy both aspects of its dual mandate: price stability and maximising employment.
However, the currently elevated levels of inflation pose a challenge for the Fed because they threaten unanchored inflation expectations — this is the key factor which could turn short-term economic factors into long-term drivers of inflation. This occurs when economic agents expect a higher level of inflation and act accordingly, for example with supermarkets raising prices and employees demanding higher wages, which creates wage-price spirals. In such a situation the Fed would have to tighten monetary policy, prioritising price stability over unemployment. The last time this occurred was under Chairman Volcker, who succeeded in reducing inflation at the cost of extremely high levels of unemployment.
The most recent FOMC meeting took place on the 3rd of November 2021. Therethe members voted to continue the policy of keeping the Federal Funds rate between 0 and 0.25%. However, they also decided that the FOMC would reduce the pace of asset purchases; this decision was made considering the rise in inflation and strength of the labour market. Specifically, they would reduce the quantity of new asset purchases by $15 billion each month from the rate of $120 billion at the time .
This decision was taken with a mind to reducing inflation amidst a 6.2% rise in the CPI without hindering recovery, particularly around the labour market .
It’s important to recognise that supply side issues are contributing heavily to inflation at present. A resurgence in demand following reopening has overtaken supply and the Fed predicts that supply chain kinks will last into 2022. Computer chips, cars and energy are all in short supply. Furthermore, labour shortages serve only to compound these issues. There are 5 million fewer jobs today than in February 2020 primarily due to reduced participation rates . The Fed has a limited ability to counteract this kind of supply-side inflation; increasing interest rates certainly won’t result in better shipping, or lower energy prices, or more cars. Alternatively, asset purchase tapering could be viewed as a means of reducing demand, but this comes at the obvious cost of growth and recovery — the recession over the pandemic was caused by a lack of demand, not supply.
Nevertheless, a 6.2% CPI increase is a 6.2% CPI increase. The Fed officially retired ‘transitory’ to describe inflation and is increasingly under pressure to address this part of its mandate. Tapering asset purchases was the natural first step in cooling the economy because raising rates while continuing asset purchases would appear contradictory. While the Fed still insists interest rate hikes are a way off, this is the first logical step towards a more hawkish position on not-so-transitory inflation.
This article was written by: Patrick Savage (Head of Federal Reserve Monetary Policy Research), Yunjia Hu (Research Associate, Federal Reserve Monetary Policy Research), Tim Doherty (Research Associate, Federal Reserve Monetary Policy Research) and Alex Campion (Research Associate, Federal Reserve Monetary Policy Research). This article was reviewed by Roberto Patiño (Head of Monetary Policy Research).
 Covid Money Tracker: https://www.covidmoneytracker.org/
 Although the FOMC didn’t explicitly name an inflation target until 2012, St. Louis Fed President James Bullard has argued that the U.S. had “an implicit inflation target of 2 percent after 1995.” What Is the Best Strategy for Extending the U.S. Economy’s Expansion? | James Bullard | St. Louis Fed (stlouisfed.org)
 Why the Fed Targets a 2 Percent Inflation Rate | St. Louis Fed (stlouisfed.org): https://www.stlouisfed.org/open-vault/2019/january/fed-inflation-target-2-percent#:~:text=To%20meet%20the%20price%20stability%20objective%2C%20Federal%20Reserve,what%20inflation%20is%20and%20how%20it%20is%20measured.
 Fred series PCEPILFE
 The Fed — June 16, 2021: FOMC Projections materials, accessible version (federalreserve.gov): https://www.federalreserve.gov/monetarypolicy/fomcprojtabl20210616.htm#:~:text=In%20conjunction%20with%20the%20Federal%20Open%20Market%20Committee,2021%20to%202023%20and%20over%20the%20longer%20run.
 Transcript of Chair Powell’s Press Conference November 3, 2021 (federalreserve.gov): https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20211103.pdf