Question

Assume that you are the manager of a firm. You are concerned about a potential increase in interestrates because it would reduce the demand for your products. Currently, economic growth is high, butannual inflation has increased from 3 percent to 5 percent within the last six months. The unemployment rate is very low and cannot go higher. The Federal Reserve (Fed) is meeting next week to assess economic conditions and set monetary policy.

(a) Given the current economic situation, should the Fed adjust or not adjust economic policy? If so, how? If not, why?
(b) Recently, the Fed has allowed the money supply to expand beyond its long-term target range. Does this affect your expectation of what the Fed will decide at its upcoming meeting?

Answer 1

(A) Concern about rising interest rates makes perfect sense, as the economy described is in a situation of overheating: high inflation, low unemployment and high economic growth. Rising inflation is a risk that requires the Fed to act to cool economic activity. This should be done through restrictive monetary policy instruments: raising interest rates and decreasing the monetary base, through the sale of government bonds and / or by increasing the banks' compulsory deposit with the Fed.

(B) This affects the credibility of the Fed, which is very bad. Economic agents base their expectations on Fed signals. If the money supply is higher than expected, real inflation will be higher than projected inflation. So expectations anchored in Fed forecasts will be dashed. This makes economic agents distrust future Fed projections.