This is What the Fed’s Monetary Policy Means To You

By William Cowie | August 06, 2014 AAA

Twice a year, the Federal Reserve’s Chair gives what amounts to the “financial state of the union” address to Congress, and it’s a good thing for everyone concerned with their finances to take five minutes or so to find out what the Federal Reserve is seeing, thinking, and about to do.

Janet Yellen delivered her latest comments a week ago, and it may be worth your while to take a few seconds out to assess what she said, because the economy is approaching another inflection point.

Inflection point? Yes, if you look at the economy (any country’s economy) you know it goes up and down in a wave pattern. That pattern always has two inflection points: the top, when the economy turns down and good times turn to bad, and of course the bottom, when things turn up again and get better. The last inflection point we had came around 2008 to 2009, when the Great Recession officially bottomed out. In the past, the time between a bottom and the next top usually ranged between five and eight years. That means we’ve entered the window for the next inflection point, which will be a top, meaning the economy will turn down again soon. This is not an alarmist statement, but merely a recap of a long-term trend which has defied all attempts to interrupt it. This approaching inflection point gives us more cause than usual to pay attention to what the individual with the most influence over the economy has to say.

In order to obtain a proper perspective about what Yellen said, it is important to understand which beacons the Federal Reserve uses to navigate the great ship of the American economy. The “big three,” spelled out specifically in the Federal Reserve Act, are:

Growth and employment: The Fed was granted its vast powers by Congress with the proviso that its actions would promote healthy economic growth and full employment by the American people (which is important to officials who need to get elected every now and then).

The economy and employment have always been regarded as two faces of the same coin: Good economic growth creates good employment opportunities for all. In practice, though, they tend to be measured and addressed separately.

Economic growth is typically measured as growth in the GDP while employment is measured by its inverse number (unemployment). Neither measure is without its controversy, but it’s the best we have. And the Fed’s goal is to keep unemployment as close to 5 percent as it can get it and GDP at a positive number, somewhere between 3 and 5 percent.

Price stability: Price stability was the second condition Congress demanded in exchange for the franchise it gave the Federal Reserve Board to manage the economy. Many people have different opinions over the definition of inflation, how it is measured, and what level is ideal. Given all of the inexactitude, the Fed has publicly stated that its goal is to keep the personal consumption expenditures (PCE) price index (as defined and measured) as close to 2 percent as it can get it.

Interest rates: Maintaining moderate interest rates was the third mandate. Of the “big three” factors, this is “the driver.” In other words, the Fed usually sets interest rates at a level to help achieve the goals set for the other two.

In addition to the “big three,” the Fed also pays attention to home prices, given how important that is for people like us.

OK, enough with the theory.

So, what did she say?

Here’s the Fed’s take on the economic state of the union: (The detailed comments, if you want to get it from the horse’s mouth, can be found here.)

Growth: GDP growth was negative for the first quarter.

At this stage of the recovery, that is unusual, to say the least. Two quarters in a row of negative growth meet the technical definition of a recession. Nobody at the Fed thinks that’s going to happen, though, blaming the GDP reduction on “transitory factors” (probably the cold winter and a mild jab at the lawmakers’ sequestration policy).

Because the Fed doesn’t think those factors are going to repeat, they don’t think we’re at the brink of the next recession, and, most important, they’re not going to react, positively or negatively.

Employment: Unemployment is 6.1 percent, the lowest since the recession, and only 1.7 percent above the pre-recession low.

The Fed’s take is: Close, but no cigar … yet. Therefore, the Federal Reserve doesn’t think its job is done in this area, especially when you look at a broader measure of employment, i.e., labor force participation. The labor force participation rate captures the proportion of every age group that has a job. The Fed uses it to include those who have given up looking for a job, something the traditional unemployment rate can’t measure.

What concerns the Fed is that the U.S. labor force participation rate has not yet recovered from the Great Recession. Some may have argued that’s because of retiring baby boomers, but this Fed chart shows the disturbing drop in the participation of those 20 to 24 years of age:

You can see the rate of participation of younger workers bounced back after prior recessions, but it hasn’t lately. Chairwoman Yellen’s Fed has noticed this and it tempers any enthusiasm they may have had for the employment situation.

Inflation: Low (around 1.5 percent), but rising.

The Federal Reserve’s inflation target is 2 percent — and they have been concerned for a long time that inflation is, if anything, too low. That concern is fading as prices are beginning to rise, and they expect inflation to continue growing for the remainder of this year.

Therefore…

The Fed’s big kahunas — the Federal Open Market Committee, or FOMC — believe the recovery of the American economy is under way, but not where they want it to be. (The FOMC has eight scheduled meetings each year, and you can read the post-meeting statements here.) Because the economy has acquired some momentum of its own, they will continue weaning the economy from its “stimulus IV” gradually.

What is stimulus IV? Two things:

  • the amount of money they inject into the economy by buying pieces of paper from banks, and
  • interest rates

A while ago, they started “tapering” the asset purchases, meaning they’re pumping a little less money into the economy every month. That will continue.

And they will hold interest rates where they are now until “about” the third quarter of 2015. This is not new; Ben Bernanke introduced that timeline back when he was king, er, Fed Chair.

How does this affect you?

1. Now you know what the Fed is looking at: unemployment, GDP and inflation. Until unemployment gets close to 5 percent, GDP grows more than 5 percent, and inflation gets over 2 percent, things will probably continue as they are. When any of those things change, you will know before the rest of the population that the Fed will react by turning on the brakes.

2. Expect more growth in the U.S. economy. Most people agree this is one of the most anemic and unbalanced recoveries in recent memory, but it is still a recovery. Perhaps because it’s so slow, we can probably expect it to continue longer than ones in the past.

3. Expect improvements in your job situation. These times carry better prospects for promotions, raises and bonuses than for the past seven years or so. It’s probably a good time to push for those.

4. Expect the stock market to continue to rise, at least in the short term. Many people are getting nervous, because the stock market seems overvalued to them, but there is nothing in the immediate economic outlook to warrant “the big one.” (Of course, that has never stopped the market from behaving erratically, has it?)

5. Expect home prices to continue to rise, as people who lost their homes in the Great Recession re-qualify for mortgages, just in time to buy another one … as the market approaches its peak. Banks, too, have more money than in many years, and they are becoming ever more eager to palm off those loans to more people. It is probably not a good time to buy a home for the first time, to upgrade, or to refinance to “tap into that equity,” because the next correction isn’t that far into the future anymore.

Overall, the message seems to be: Keep on keeping on, or, as Young Mr. Grace always used to say on the British sitcom “Are You Being Served?”: “You’re all doing very well!”

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