Us Economy Term Paper

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Macroeconomics

The current macroeconomic situation of the United States is generally positive. The major indicators -- GDP growth, unemployment, inflation and interest rates are all trending in the right direction, indicating the sort of stable economic growth that it the goal of monetary and fiscal policymakers. The following graph illustrates the trends for the past ten years for GDP growth and the unemployment rate:

What this shows is that the GDP contracted during the period 2008-2010 (roughly), coinciding with the Great Recession. Since that point, the GDP growth rate has been relatively sluggish, without a steady upward trend in the trendline, until recently. Only in the past couple of quarters has there been a return to a more normal rate of growth in the GDP (BEA, 2014).

The unemployment rate is a lagging indicator, and should move inverse to the GDP growth rate. The chart above shows this relationship. There is a slight lag. It is only a few months which is tougher to see on a 10-year graph but the lag exists. And, as expected, when the GDP collapsed the unemployment rate spiked. As the GDP has shown a general upward trend, unemployment has shown a general downward trend. The result is that the GDP gain is at the best level since before the recession, while unemployment is at its lowest level since just before the recession. Both trends are healthy, and moving in the right direction, towards a restoration of the normal course of events prior to the recession.

There are other major economic metrics besides these two. For example, the central bank is charged with managing the rate of inflation in the economy. A rate too high, the prices erode consumer spending power; a rate too low and there is a risk that people cannot earn a return on their investments. It is for this reason that the Federal Reserve has a target inflation rate of 2% (BoG FRS, 2014).

There are two main measures of inflation. The first ist the consumer price index, or CPI. This is a basic basket of goods, turned into an index, to determine the change in the cost of living. The CPI increased 1.7% in October 2014. The other main figure in inflation is the core CPI, which omits the more volatile food and energy figures from the calculation. The core CPI is thus a smoother number, one that should more accurately reflect long-run inflation in the economy. The core CPI was 0.2% in October, which means that actual inflatoin is much lower than the headline inflation number. Food prices increased while energy prices decreased in the month, accounting for the difference.

What these figures show is that the inflation rate for the past twelve months has remained below the Fed's target, but not much below. If the inflation rate was strongly above or below the Fed's target, there might be a case to be made for corrective action, but this level is reasonable in the economy, especially since the economy is growing. A growing economy increases the risk of inflation, so while the inflation number remains below the Fed's target, it is not far below and if it moves, that move is more likely to be to a higher level of inflation. The only constraint to that is falling fuel prices, which when they work through the economy will constrain price growth.

A final metric that is key to understanding macroeconomc health is the interest rate. A good rate to measure by is the Fed funds rate, which serves as a guidepost for monetary policy, though the actual monetary policy is more likely carried out via open market transactions. The Fed funds rate was dropped to 0.25% during the Great Recession as a means of implementing expansionary monetary policy. The economy was in a liquidity trap, however, as adding liquidity to the system did not encourage either business investment or consumer spending, due to fears about ongoing contagion in the financial markets.

The Fed funds rate today is still between 0-0.25%, as it has been since the outset of the crisis (FRBNY, 2014). This rate is low, and highly expansionary. With a rate this high, there is risk that the economy will expand too quickly, which would lead to inflation.

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At the present moment, there is no inflation in the economy, and the GDP growth rate is healthy rather than overheated. Nevertheless, the time might be coming soon for the Federal Reserve to start raising rates, so that it can do so gradually and proactively, rather than being forced to raise them rapidly to head off an assset bubble, as happened in the 2000s.

Policy Prescriptions

In theory, there could still be some role for fiscal policy. The time for aggressive fiscal policy was, alas, several years ago, and the economy at this point is growing at a healthy rate. Fiscal policy could target some of this growth, to ensure that capital does not converge on specific sectors to create bubbles. But otherwise, there is not much need for fiscal policy provisions at the current moment in time. The economy is not strong enough to indulge in spending cuts, but neither is there a signfiicant role for anything other than minor, targeted spending.

Which is good, because realistically there is not going to be any fiscal policy stimulus forthcoming -- if it wasn't happening in 2010 it certainly will not happen now.

There is much greater need for attention to monetary policy. There are three major monetary policy instruments -- the reserve requirements, th Fed funds rate and the open market transactions. Realistically, the reserve requirements are the most difficult to change and it is highly unlikely that they will be subjec to change as a result. The Fed funds rate is the rate at which financial institutions borrow money from the government. While it is changed as a means of controlling the money supply, there is defintely a risk tha the Fed funds rate will need to increase. It is not something that is a major factor in the state of the economy it seems, and the Fed itself views it more as symbolic of the direction that the Fed is taking. But it will need to signal to the markets that with improved economic perofrmance, and underlying factors like declining oil prices, that in all likelihood we are entering into a period of robust ecoomic growth, and the rates will need to increase.

The open market transactions are the means by which the Fed is going to affect the money supply. Up until very recently, it engaged heavily in expansionary policy. Not only did it buy short-term Treasuries to increase the money supply, but it was buying long-term Treasuries as well, something that was a little more unorthodox. With the improvements in the economy evident, that form of monetary policy has to come to an end, but there may be call for purchases of short-term Treasuries to wind down as well.

All told, monetary policy should reflect that the economy is starting to grow. The central bank doubtless wants to see the economy get back closer to its pre-recession trend line, and may continue to engage in expansionary policy to see that happen. But the economy right now is very healthy. If it was frozen like this, that would not be too bad. There is a need to prolong most metrics, while bringing the unemployment rate down a little more, back to pre-recession levels. As a lagging indicator, the unemployment rate is probably already set to continue dropping.

So the big moves needed in terms of monetary policy are to gradually signal shift towards removing the last of the stimulatory policies from action. This means raising the Fed funds rate target, and it means beginning to slow down the expansinoary open market transactions. The objective of these changes will be to maintain GDP growth, continue to bring down unemployment but also to make sure that inflation does not get carried away.

This is entirely feasible, and if done gradually it will not cause a disruption in the financial markets, but rather a return to normalcy. The next major change in monetary policy would therefore not come until there has been some sort of shock that the Fed needs to respond to. Perhaps continued drop in oil prices will spur an asset bubble -- that seems like one of the bigger risks at presetn in the economy, so that is the sort of thing that the.....

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