Federal Reserve Actions Over the Last Four Decades
For the period from the mid-1970s up through the end of 2007, Federal Reserve monetary policy can largely be summed up by looking at how it targeted the federal funds interest rate using open market operations.
Of course, telling the story of the U.S. economy since 1975 in terms of Federal Reserve actions leaves out many other macroeconomic factors that were influencing unemployment, recession, economic growth, and inflation over this time. The nine episodes of Federal Reserve action outlined in the sections below also demonstrate that the central bank should be considered one of the leading actors influencing the macro economy. As noted earlier, the single person with the greatest power to influence the U.S. economy is probably the chairperson of the Federal Reserve.
Figure 14.10 shows how the Federal Reserve has carried out monetary policy by targeting the federal funds interest rate in the last few decades. The graph shows the federal funds interest rate—remember, this interest rate is set through open market operations—the unemployment rate, and the inflation rate since 1975. Different episodes of monetary policy during this period are indicated in the figure.
Episode 1
Consider Episode 1 in the late 1970s. The rate of inflation was very high, exceeding 10 percent in 1979 and 1980, so the Federal Reserve used tight monetary policy to raise interest rates, with the federal funds rate rising from 5.5 percent in 1977 to 16.4 percent in 1981. By 1983, inflation was down to 3.2 percent, but aggregate demand contracted sharply enough that back-to-back recessions occurred in 1980 and in 1981–1982, and the unemployment rate rose from 5.8 percent in 1979 to 9.7 percent in 1982.
Episode 2
In Episode 2, when the Federal Reserve was persuaded in the early 1980s that inflation was declining, the Fed began slashing interest rates to reduce unemployment. The federal funds interest rate fell from 16.4 percent in 1981 to 6.8 percent in 1986. By 1986 or so, inflation had fallen to about 2 percent and the unemployment rate had come down to 7 percent, and was still falling.
Episode 3
However, in Episode 3 in the late 1980s, inflation appeared to be creeping up again, rising from 2 percent in 1986 up toward 5 percent by 1989. In response, the Federal Reserve used contractionary monetary policy to raise the federal funds rates from 6.6 percent in 1987 to 9.2 percent in 1989. The tighter monetary policy stopped inflation, which fell from above 5 percent in 1990 to under 3 percent in 1992, but it also helped to cause the recession of 1990–1991, and the unemployment rate rose from 5.3 percent in 1989 to 7.5 percent by 1992.
Episode 4
In Episode 4, in the early 1990s, when the Federal Reserve was confident that inflation was back under control, it reduced interest rates, with the federal funds interest rate falling from 8.1 percent in 1990 to 3.5 percent in 1992. As the economy expanded, the unemployment rate declined from 7.5 percent in 1992 to less than 5 percent by 1997.
Episodes 5 and 6
In Episodes 5 and 6, the Federal Reserve perceived a risk of inflation and raised the federal funds rate from 3 percent to 5.8 percent from 1993 to 1995. Inflation did not rise, and the period of economic growth during the 1990s continued. Then in 1999 and 2000, the Fed was concerned that inflation seemed to be creeping up, so it raised the federal funds interest rate from 4.6 percent in December 1998 to 6.5 percent in June 2000. By early 2001, inflation was declining again, but a recession occurred in 2001. Between 2000 and 2002, the unemployment rate rose from 4.0 percent to 5.8 percent.
Episodes 7 and 8
In Episodes 7 and 8, the Federal Reserve conducted a loose monetary policy and slashed the federal funds rate from 6.2 percent in 2000 to just 1.7 percent in 2002, and then again to 1 percent in 2003. It actually did this because of fear of Japan-style deflation: This persuaded it to lower the Fed funds further than they otherwise would have. The recession ended, but unemployment rates were slow to decline in the early 2000s. Finally, in 2004, the unemployment rate declined and the Federal Reserve began to raise the federal funds rate until it reached 5 percent by 2007.
Episode 9
In Episode 9, as the Great Recession took hold in 2008, the Federal Reserve was quick to slash interest rates, taking them down to 2 percent in 2008 and to nearly 0 percent in 2009. When the Fed had taken interest rates down to near zero by December 2008, the economy was still deep in recession. Open market operations could not make the interest rate turn negative. The Federal Reserve had to think “outside the box.”