Question

In Dec, 2018 the fed funds rate is 2.25-2.5% which is the rate that banks charge each other to borrow reserves overnight. The fed controls the supply of bank reserves by buying or selling Treasury Securities. (Buying treasuries raises the supply of bank reserves and therefore lowers the fed funds rate) It is also gradually undoing quantitative easing(QE) which means shrinking its balance sheet which has assets of 4Trillion! The fed had expanded its balance sheet by creating money to buy long- term bonds since the fed funds rate had fallen to 0% and the fed wanted more stimulus following the Great Recession of 2008-2009. In addition fiscal policy was stimulated by the Trump Tax Cuts and a big rise in government spending which could threaten inflation by stimulating economy. The fed has its hands full as inflation rises to its target of 2%! The fed follows the consumption price deflator which is still below 2%(But the CPI is rising at an annual rate of 2.2%) The fed is expected to keep interest rates steady and undo QE very very gradually. Do you think the fed policy is too tight, too loose or about right. More importantly Why? Please include a detailed explanation that backs up your answer. Do you think the fed will raise interest more in 2019? What is the neutral rate? Why is that important? Do you think the fed should use financial market or economic indicators for policy. Why?

Answer 1

Fed policy is extremely right in increasing interest rates gradually via quantitative easing method as the US Economy has seen inflation in CPI terms around 2.2% and employment near to reaching full employment where only 4,00,000 workers unemployed as of December's 2018 on approximately basis. Since unemployed workers in kesser number tham ever it tends to create higher buying power which may raise prices if goods coupled by Trump Tax cjts as an expansionary fiscal policy which can further aggravate inflation near 3%.

Hence US Fed tries to balance the economy into robustness by increasing interest rates such that inflation and unemployment in control at the same time economic real GDP grows at steady state with help of expansionary fiscal policy by Trump Administration .

Looking forward FEd shall raise interest rates by another 75 basis point at maximum in 2019. The neutral rate comes around 2%. Fed should use financial indicators albeit these indicators are highly indicative and lack concrete methodical approach.

Hence FEd must rely on financial indicators to some extent but also more in independent research and secondary research .