The Federal Reserve Board What It Is, and Why

							The Federal Reserve Board:
  What It Is, and Why It
         Matters


     CEPR Basic Economics Seminar
             Dean Baker
          November 3, 2005
The Federal Reserve Board:
What it Is and Why it Matters
1. Unemployment and Poverty
2. How the Fed Affects Unemployment
3. The Non-Accelerating Inflation Rate
   of Unemployment (NAIRU)
4. Who Controls the Fed?
5. The European Central Bank and the
   European Welfare State
          Low Unemployment is the
          Best Anti-Poverty Measure
                Poverty Rates and Unem ploym ent Rates

          40

          30
Percent




          20

          10

           0
               1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
                                               Year

                        Un. Rate                      Poverty Rate -All
                        Poverty Rate - black          Poverty Rate - Hispanic
   Low Unemployment is the
   Best Anti-Poverty Measure

• As the unemployment rate fell from over 7
  percent to 4 percent, the poverty rate
  dropped from 15.1 percent to 11.3 percent.

• The poverty rates for African Americans
  and Hispanics fell by almost 10 PP.
         Low Unemployment
      Disproportionately Benefits
         Blacks and Hispanics
               Comparing Unem     ent
                             ploym Rates: 1994 and 2000

          40
                                                         35.2
          35
          30
                                                                24.3
          25
Percent




          20
          15                 11.5            9.9
          10     6.1                7.6
                                                   5.7
                         4
          5
          0
                   All        black          Hispanic    black teen

                                     1994   2000
         Low Unemployment
      Disproportionately Benefits
         Blacks and Hispanics

• The unemployment rate for Blacks is typically twice
  the overall unemployment rate.

• The unemployment rate for Hispanics is typically one
  and a half times the overall unemployment rate.

• The unemployment rate for Black teens is typically six
  times the overall unemployment rate.
              Low Unemployment
          Disproportionately Benefits
             Lower Wage Workers
                Wage Growth by Percentile: 89-85 vs. 95-00

          12         11.1                                          10.6
          10                                       8.7
                                  7.7
          8
                                                             5.4
          6
Percent




          4                                  3.3
               1.8
          2
          0
          -2    10th            50th          90th            95th
                             -1.8
          -4

                                1989-95   1995-2000
           Low Unemployment
       Disproportionately Benefits
          Lower Wage Workers
• Wages for workers at the middle and bottom of the wage
  distribution stagnated from the eighties until the mid-
  nineties.

• Workers at all points along the wage distribution
  experienced healthy wage growth during the years of
  relatively low unemployment from 1995-2000.

• When the unemployment rate is low, workers can also
  push for better working condition and demand things
  like health care coverage and child care subsidies.
         How the Fed Affects the
          Unemployment Rate
• The Fed controls the short-term interest rate – the
  federal funds rate (other tools include bank regulations
  and margin requirements for buying stock).
• The short-term interest has some impact on business
  activity because it affects the cost of borrowing money to
  maintain business operations (higher costs, less
  business).
• Higher short-term interest rates generally lead to higher
  long-term interest rates (car loans, mortgages, corporate
  bonds).
       How the Fed Affects the
        Unemployment Rate
• Higher long-term rates reduce home building,
  consumer borrowing, and investment.

• In general, higher short-term interest rates, mean
  higher long-term interest rates, which means slower
  growth and higher unemployment.

• It is easier to slow the economy with high interest
  rates, than boost the economy with low interest rates.
 The Story of the Non-Accelerating Inflation
      Rate of Unemployment (NAIRU)
• Common sense – lower unemployment rates, are
  associated with a stronger economy – other things equal,
  this should mean more inflationary pressure.
• The NAIRU vs. common sense – according to the NAIRU
  theory, there is a level of unemployment, where the
  inflationary rate will stay fixed through time. If the
  unemployment rate is higher than NAIRU, then inflation
  falls. If the unemployment rate is lower than NAIRU, then
  inflation rises.
• There is no widely accepted theoretical basis for the NAIRU
  – in other words, there is no generally accepted view as to
  why such a level of unemployment would exist.
The Story of the Non-Accelerating Inflation
     Rate of Unemployment (NAIRU)


  • Statistical evidence gave a reasonably good fit for a
    NAIRU of 6.0 percent in the United States prior to
    1994.

  • The vast majority of mainstream economists
    believed in a 6.0 percent NAIRU prior to 1994.
              The Importance of a
              6.0 Percent NAIRU
• No one wants continually accelerating inflation – 2 percent
  inflation rises to 3 percent, then to 5 percent, then to 10
  percent, and pretty soon we have hyperinflation and the
  currency becomes worthless.

• The NAIRU was used as an argument for raising interest
  rates and keeping the unemployment rate from falling in
  the late eighties and again in 1994.

• Greenspan raised the short-term interest from 3.0 percent
  in February of 1994 to 6.0 percent in March of 1995.

• If the Fed does not want the unemployment to fall, it can
  keep the unemployment rate from falling.
        The Greenspan Moment
• In the summer of 1995, the economy was slowing, but
  the unemployment rate was still under 6.0 percent (i.e.
  below NAIRU) Greenspan lowered the interest rate.

• The economy picked up and the unemployment rate
  began to fall, dropping below 5.0 percent in 1997, and
  eventually falling to 4.0 percent in 2000.

• There was huge opposition within the economics
  profession to Greenspan’s decision to allow the
  unemployment rate to fall (including from Clinton’s
  appointees to the Fed).
       The Greenspan Moment
• Greenspan (and the non-mainstream economists)
  was right – there was virtually no acceleration in the
  inflation rate over the six years from 1994 to 2000
  when the unemployment rate was below the standard
  measures of NAIRU.

• If Greenspan would have listened to the conventional
  economists, the unemployment rate never would
  have fallen much below 6.0 percent and we never
  would have gotten the enormous gains in wage
  growth and poverty reduction associated with lower
  unemployment.
           Who Runs the Fed?
• The Open Market Committee – 7 Fed governors
  (appointed by the president) + 5 regional bank
  presidents.

• The 12 Regional Fed Banks – controlled largely by
  bankers, but with opportunities for democratic input.

• The Law Governing the Fed – the Humphrey-Hawkins
  Full Employment Act requires the Fed to pursue price
  stability and full employment (defined as 4.0 percent
  unemployment).
        The Politics of the Fed

• Answering to financial markets – failing on inflation
  gets you in trouble, failing on unemployment doesn’t.

• The public is very poorly informed about what the
  Fed does and how it affects them.

• No one understands NAIRU and its policy
  implications – that an agency of the government (the
  Fed) would deliberately raise the unemployment rate.
           The Politics of the Fed
• Deciding between the costs of higher unemployment
  and risks of higher inflation is a political decision –
  different people bear these costs.

• The financial sector is very scared of having public
  debates over Fed policy. They use euphemisms to avoid
  having a public discussion of the actual policy (e.g.
  raising interest rates to keep the economy from
  overheating).

• The mid-nineties debate over the NAIRU (insofar as it
  existed) was over growth rates – NOT levels of
  unemployment.
The European Central Bank (ECB)
 and the European Welfare State
• The ECB has the sole goal of maintaining price stability
  defined as keeping inflation under 2.0 percent.

• The ECB has generally maintained a far more
  contractionary monetary policy than the Fed.

• Virtually all economists would agree that if
  Greenspan’s monetary policy had been as
  contractionary as the policy followed by the ECB,
  growth in the United States would have been lower and
  unemployment would be higher.
The European Central Bank (ECB)
 and the European Welfare State
• It is reasonable to believe that the contractionary monetary
  policy of the ECB has been an important factor in high
  European unemployment.

• If ECB policies raise the unemployment rate, then they also
  put more strains on the welfare state. Higher
  unemployment and slower growth raise government
  expenditures (e.g. unemployment insurance) and reduce
  tax revenue, thereby increasing the size of the government
  deficit.

• The ECB is largely protected against democratic input.
        Conclusion – Know What
         the Fed is Doing to You!
1.   The level of the unemployment rate has an enormous
     impact on the well-being of most of the population – it
     swamps the impact of any politically feasible anti-
     poverty program.
2. The Fed can have a huge impact on the level of the
   unemployment rate – especially in keeping it high.
3. The Fed is not the market.
4. The public has a right to hold the Fed accountable for its
   performance.
                      Reading List

• Bernstein, J. and D. Baker, 2004. The Benefits of Full
  Employment, Washington, D.C.: The Economic Policy
  Institute.

• Galbraith, J. 1998. Created Unequal: The Crisis In
  American Pay, New York: The Century Foundation.

• Greider, W. 1987. Secrets of the Temple: How the Federal
  Reserve Board Runs the Country. New York: Simon and
  Schuster.

• The Financial Markets Center [www.fmcenter.org].
 The Federal Reserve Board:
What It Is, and Why It Matters

              Dean Baker
            baker@cepr.net

Center for Economic and Policy Research
             www.cepr.net