Monetary Policy 2002-2004 Essay

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Macroeconomics

The two-year time period that will be covered in from the middle of 2002 to the middle of 2004. Starting with Q3 in 2002, the GDP figures during this time period were as follows:

Nominal

Real GDP

Trailing

GDP

(2009 chained)

change

This data shows that the economy was facing conditions of accelerating growth during this time period. The economy was improving relatively slowly during the latter stages of 2002 and into Q1 2003, but after that the growth began to accelerate. The trailing 12-months' growth rate was over 4% for Q4 2003 and the first half of 2004. Thus, the economy was in a period of robust growth, strong enough that there may have been inflationary pressures. The inflation rate during this period was as follows:

Y/Y

Y/Y

Jul-02

Jul-03

Aug-02

Aug-03

Oct-02

Oct-03

Nov-02

Nov-03

Dec-02

Dec-03

Jan-03

Jan-04

Feb-03

3%

Feb-04

1.70%

3%

1.70%

Apr-03

2.20%

Apr-04

2.30%

May-03

2.10%

May-04

3.10%

Jun-03

2.10%

Jun-04

3.30%

Source: BLS (2014)

These figures shows that during the period where GDP growth was relatively slow, the inflation rate was mostly within the bounds of what the Fed has targeted. Today it targets 2%, though that might not have been official policy back then. The key phrase, however, is over time. Nevertheless, with inflation over the Fed's target rate for a period of one full year from November 2002 to October 2003, and then back above in April 2004, the normal, expected policy response would be to increase interest rates in order to cool the economy.

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When inflation is too high, consumers lose their buying power, especially since wages are sticky. When consumers lose their buying power, this creates a net loss of wealth. Moreover, investors need to take greater risks to earn positive real returns, unless interest rates increase. So with a period of GDP growth and inflation above the Fed's target, the Federal Reserve should have guided monetary policy in a manner that was somewhat cautionary. This probably would have included a couple of small increases in the interest rate to cool inflationary pressure during the two-year period where inflation was above the 2% watermark, and perhaps another rate increase in the spring of 2004 when the inflation rate shot up rapidly. The Fed's response during this period, in terms of the target Fed funds rate, is as follows:

Fed Funds Rate, end of month

Jul-02

1.75%

Jul-03

1.00%

Aug-02

1.75%

Aug-03

1.00%

1.75%

1.00%

Oct-02

1.75%

Oct-03

1.00%

Nov-02

1.25%

Nov-03

1.00%

Dec-02

1.25%

Dec-03

1.00%

Jan-03

1.25%

Jan-04

1.00%

Feb-03

1.25%

Feb-04

1.00%

1.25%

1.00%

Apr-03

1.25%

Apr-04

1.00%

May-03

1.25%

May-04

1.00%

Jun-03

1.00%

Jun-04

1.25%

Source: New York Fed (2014)

What this shows is that the interest rates were cut when inflation started to rise. Rather than reversing course on this, the Fed cut rates further in June 2003. Through the rapid rise in inflation in early 2003 and persistently high inflation thereafter, interest rates were.....

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