Magazine article Economic Trends

The Economy in Perspective

Magazine article Economic Trends

The Economy in Perspective

Article excerpt

On the policy trail ... The Federal Open Market Committee has maintained its federal funds rate target at 1% for almost a full year, by most reckonings a considerable length of time. With inflation close to 1% and inflation expectations also very low, the real federal funds rate has stayed in the neighborhood of zero during that period. This situation is unusual but not unprecedented--the FOMC set the real funds rate near zero for a period in the aftermath of the 1990-91 recession.

As of May, nonfarm payroll employment is still 1.6 million below its level at the peak of the last business cycle in March 2001. The nation's 5.6% unemployment rate is above the 2000 peak of roughly 4.0%. Similarly, many industries' capacity utilization rates lie well below their pre-recession peaks. So, despite recent reports of accelerating economic activity, it is not surprising that many analysts think the economy is operating below its full-employment potential.

Although the theoretical concept of full employment potential and its cousins--potential output, the nonaccelerating inflation rate of unemployment (NAIRU), and the natural rate of interest--variously describe ideal economic conditions, policymakers face challenges in determining how to implement the concepts empirically and use them in real-time situations. Theoretically, each of these concepts can be thought of as indicating the output level, the rate of unemployment, or the interest rate that would prevail in an economy where supply and demand are balanced in all markets. Generally, no more resources could be employed without reducing overall social welfare.

How can policymakers constructively contribute to the attainment of ideal conditions? A central bank could attempt, in effect, to keep its policy rate on a path consistent with an economy evolving toward full resource utilization with price stability. Unfortunately, even the wisest and best-intentioned central banks are not omniscient. While trying to remain on this so-called neutral policy path, policymakers necessarily must rely on a constellation of judgments about economic structure and forecasts.

Why are policy rates not always characterized as neutral? Why are they sometimes described as "accommodating"? This terminology could mean that policymakers are simply accommodating an increased demand for liquidity by lowering the price of bank reserves as the economy evolves along its equilibrium path. …

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