US Central Bank Decision-Making
By Sandra Ng, Brooklyn Han, Anna Clarey and Pedro Almas
- Introduction
Previously, we introduced the US Federal Reserve (‘the Fed’). The Fed employs many monetary policy tools in pursuit of its dual mandate of maintaining price stability and promoting maximum employment. In this article, we explore the thought process that goes into monetary policy, using the policy decisions made by the Federal Open Market Committee (FOMC) in June 2020 as a case study. We will dive into the data consulted by the FOMC, how this data was interpreted, and how the FOMC’s analysis led to their final policy decisions.
2. Information Set
Broadly speaking, the Fed seeks to evaluate the current level of economic activity and forecast a likely future path. This then allows them to evaluate what policy actions are necessary. To do so, they take into account a range of economic variables relating to inflation, employment and economic output. Specifically, each member of the FOMC creates their own Summary of Economic Projections (SEP) outlining how they believe these key variables will trend in each of the next few years and their projected long-run value.
Inflation
In order to effectively approach its price stability mandate, the Fed analyses the inflation rate, which is the rate at which the overall prices of goods and services are increasing.
The two main inflation measures used to track price movements in consumer goods and services are the Personal Consumption Expenditures (PCE) Price Index and the Consumer Price Index (CPI). Both indexes calculate the price level by pricing a basket of goods. The CPI is the more well-known economic indicator and usually gets more attention from the media as a global measurement used since 1919, whereas the PCE index was first reported 40 years later in 1959, and is used only by the United States. The differences between the two measures is summarised in Figure 1.
The Fed prefers to use the PCE as it is a broader measurement of inflation, considering both urban and rural spending, whereas the CPI focuses on urban spending and is less volatile. Following the dual mandate, the Fed wants to monitor price changes so that they are stable, and the PCE provides a comprehensive view and is less likely to be affected by price swings giving a more accurate result.
Employment
Concerning its employment maximisation mandate, the Fed looks mainly at the unemployment rate. The unemployment rate is the percentage of the labour force that is jobless. Note that this is not a percentage of the whole population; rather, the labour force is the set of people who are actively seeking work, and this number is determined via surveys. It is a lagging indicator, meaning that it generally rises or falls in the wake of changing economic conditions, rather than anticipating them.
It is also helpful to consider the participation rate, which measures the percentage of Americans who are members of the labour force. Social, demographic and economic trends influence the labour force participation rate. Retirees, discouraged unemployed workers who give up looking for jobs, and stay-at-home parents are examples of Americans who do not participate in the labour force. Combining participation rate with unemployment rate when analysing the job market can offer a clearer picture. A high participation rate alongside a low unemployment rate is a sign of a robust job market.
Finally, another indicator that is relevant when assessing the state of employment is the employment-to-population ratio. It measures the number of people employed over the total working-age population. Unlike the unemployment rate, the employment-to-population ratio takes into account unemployed people not looking for jobs. One of the characteristic features of this indicator is that it is not affected by short-term fluctuations.
Output
As mentioned above, the Fed also looks at indicators relating to economic output in order to assess the overall health of the economy. The Gross Domestic Product (GDP) growth rate is the main indicator in this area. It is the percentage change in value of all the goods and services produced in a nation during a period of time compared to an earlier period. The GDP growth rate is used to measure the comparative health of an economy over time.
GDP can be looked at from two different perspectives. Nominal GDP measures the value of goods and services in an economy using current prices. Real GDP also measures a country’s total economic output but adjusted for inflation. As such, real GDP is a more meaningful statistic to assess economic performance. In fact, nominal GDP is exaggerated by inflation. If we only analyse nominal GDP, it is difficult to understand whether output is actually expanding or if it is just prices that are rising in the economy.
The real GDP growth rate is, then, a more insightful indicator than the nominal GDP growth rate as it considers the effects of inflation on economic data. It avoids the distortion caused by periods of high inflation or deflation. Therefore, it makes sense that real GDP growth rate is preferred by economists for macroeconomic analysis and central bank planning purposes.
Financial Stability
Aside from inflation and employment, the Fed also has a responsibility to maintain the stability of financial markets. A key concern is market liquidity. Market participants are more willing to invest in highly liquid securities such as short-term Treasuries because they are more easily converted into cash and therefore seen as less risky. In low liquidity environments, as compensation for the higher risk, treasury yields tend to rise sharply. High treasury yields flow through into higher interest rates on other types of loans. This could compel families to cut back on necessities and businesses to downsize and close.
A key measure of market liquidity is the bid-ask spread due to the availability of high-frequency data. It is given by:
Bid-ask spread = Ask Price — Bid Price
In a financial market, the bid price can be thought of as what the broker pays the seller of a security, and the ask price as what the buyer pays the broker for the same security. The ask price is higher than the bid price as the broker profits from the difference. This difference, the bid-ask spread, is a transaction cost. Lower bid-ask spreads indicate better liquidity.
3. Decision-Making Process
An overall analysis of currently available data and forecasts is used in determining the appropriate policy action.
3.1 Inflation, Employment and Output
Current data
Firstly, current data showed a deviation from the Fed’s inflation and employment goals.
To evaluate its performance on the ‘inflation’ aspect of the dual mandate, the Federal Reserve collects data on the personal consumption expenditure price index (PCE), whereas the Federal government considers the consumer price index (CPI). The 12-month inflation rate for headline PCE is announced monthly. In June, inflation had fallen below the Fed’s symmetric 2% objective, as shown in Figure 2. This low inflation level as expected reflected the economy in June, with weak consumer spending, relatively high unemployment and low consumer confidence due to the pandemic and the nation-wide lockdown.
Recovery in employment was uneven; while some sectors improved, the overall unemployment rate had risen approximately 10 percentage points since February, to 13.3%, the highest civilian unemployment levels in the last 15 years as shown in Figure 3. The ‘K-shaped recovery’ can explain why there has been uneven recovery, as different industries recover at different rates and sectors diverge from one another. Sectors where recovery was strong include: technology, retail and pharmaceuticals, as these are the considered essential goods in a time where physical contact is not available and a vaccine must be created. However, other sectors have been badly affected such as: hospitality, travel and entertainment. It is likely that this will have a long-term impact on the income distribution within the economy, as sectors that are recovering are able to increase their profits and employ more workers whereas recovering sectors will experience sluggish growth and will struggle to hire more employees.
A nuance to note is that although employment figures looked strong in May, the extent of unemployment was likely understated. Compared to April, there was a large increase in the number of workers who reported themselves as employed in May but were absent from their jobs. Furthermore, the employment cost index for total labour compensation rose and average hourly earnings decreased, pushing the Fed further away from reaching its aim to maximise employment.
Output suffered a steep decrease in the second quarter of 2020 of an unprecedented 31.4 percent, but recovered sharply in the third quarter by 33.1 percent, as shown in Figure 4. One may speculate that this is due to the large volume of unused capacity in the economy caused by inactivity due to the pandemic, as well as higher levels of personal spending and renewed consumer confidence starting in June 2020.
Projections
Beyond current deviations from the mandate, the Fed also makes a self-assessment of whether it can achieve the mandate in the longer run. This is reflected in the Summary of Economic Projections (SEP), where participants of the recent FOMC meeting in June 2020 submitted their predictions of what GDP growth, unemployment rate and inflation would be in each of 2020, 2021 and 2022, and for the long run. They forecast:
- a large output gap over the next two years
- low inflation for the coming years
- real GDP will grow faster than the long-run growth rate in 2021 and 2022.
- In spite of severe job losses in 2020, the Fed policymakers did not change their forecast for long-run employment; they were not expecting long-term damage overall.
Each individual FOMC member makes these predictions under the assumption of appropriate monetary policy, which is their individual preference for the future policy path. This set of forecasts was published in June 2020, after aggressive actions including lowering the policy rate and setting up emergency lending tools had already been taken in March. It reflects the Fed’s belief that while there are near-term challenges, current policy actions are sufficient to bring them back to their goals in the longer term. As such, chair Powell expressed the view that ‘monetary policy (was) in a good place’.
Further Analysis
Besides simplistically looking at the statistics, the Fed also qualitatively evaluated the drivers of the numbers and the implications on their outlook. For example, the extent of the downturn and pace of recovery would depend on the success in containing the virus and the policy response. Some hard-hit industries (e.g. hospitality, travel and entertainment) may not see jobs recover for a long time, and that could affect labour force participation.
They also analysed alternative policies that had yet to be implemented, but were worthy of consideration; an example in this instance was strengthening forward guidance. Simulations suggested that this would aid labour market recovery. However, there was doubt over how to implement forward guidance effectively — whether it should be linked to inflation outcomes in relation to the 2% average target rate, the unemployment rate for credibility or on a calendar-based guidance. With an uncertain economic future, the calendar-based guidance approach did not seem realistic and concerns arose that maintaining low interest rates as part of a commitment to forward guidance may cause further financial instability. This ended with the Fed deciding against strengthening forward guidance, and that further intentions would be clarified in future meetings. (4.3)
3.2 Financial Market Stability
In March 2020, financial markets panicked in response to coronavirus-induced lockdowns. The bid-ask spread, a key measure of liquidity, is typically a few cents per $100, but rose to almost 50 cents per $100. This indicated a severe deterioration of liquidity conditions, arising from a reduction in investor confidence. Investors were selling off long-term securities in exchange for shorter-term liquid assets that would satisfy their imminent consumption needs, but there were not enough buyers. This caused the yield on long-term securities to rise sharply.
The Fed’s response in March was to purchase massive quantities of securities in markets where credit was at risk of drying up. Repurchased securities included US Treasury securities and agency mortgage-backed securities. In doing so, the Fed greatly expanded its balance sheet and provided ample reserves to financial institutions, promoting short-term lending by banks to households and firms. Further, by engaging in repurchasing, the Fed contributed to financial market stability by providing a reliable source of demand for these securities when investor confidence was weak. This prevented asset prices from declining significantly and restored stability. (4.2)
4. Final Decisions
Following the June 2020 meeting, the Fed’s three main final decisions are as follows.
4.1 Interest Rate
The Federal Funds Rate was to be kept close to the effective lower bound, between 0 to 0.25 percent until the economy has visibly recovered and is on track to meeting the Fed’s dual mandate objectives. The rate is set low so as to not impede the economic recovery, encouraging households to consume by increasing the opportunity cost of saving.
4.2 Asset Purchases
By June 2020, market liquidity as measured by the bid-ask spread had improved, and the Fed had stepped down the rate of asset purchases. From a peak of approximately $75 billion and $41 billion daily purchases of Treasury securities and agency MBS in late March, the average daily amount in June was around $4.0 billion for Treasury securities and $4.5 billion for agency MBS. However, the bid-ask spreads on longer maturity securities in particular had not fully recovered to pre-pandemic levels. This motivated the final decision to continue asset purchases, albeit at this reduced rate.
4.3 Forward Guidance
The FOMC did not make an explicit decision on whether to utilise a more forceful form of forward guidance and acknowledge that this is open for discussion in future meetings. As such, the current forward guidance remained unchanged, which is that the FFR would remain close to the effective lower bound indefinitely. However, the FOMC was aware that firms’ and households’ expectations may hinder the effectiveness of the current forward guidance with worries that it is too ‘passive’.
This article is written by: Sandra Ng (Head of US Monetary Policy Research), Brooklyn Han (Research Associate, US Monetary Policy Research), Anna Clarey (Research Associate, US Monetary Policy Research) and Pedro Almas (Research Associate, US Monetary Policy Research). This article is reviewed by Jason Jia (VP, Monetary Policy Research).