Interest Rate Forecasting -- "What the Federal Reserve Watches"
by C. M. Corky Watts
The Federal Reserve is the central bank of the United States. It is an independent agency of the Federal government, but key positions are appointed by the President and confirmed by Congress. The Federal Reserve is composed of twelve regional banks and has a board of governors that oversees its activities. The central bank provides liquidity to reserve member banks, regulates bank holding companies and monitors growth of the U.S. money supply. Over the years, the Feds have become the gate keeper of domestic economic growth and the rate of inflation.
The Federal Reserve uses two methods to maintain modest economic growth with low inflation. First, they implement a monetary policy that assures a steady but modest growth of money. Second, they establish the borrowing rate on two key financial instruments -- the Federal Funds Rate, the borrowing rate on loans between commercial banks and the Federal Reserve Discount Rate, the rate of interest on funds borrowed by commercial banks from the Federal Reserve. Both key rates help to control the growth of money. In the past several years, the Federal Reserve has been successful in maintaining modest economic growth, high employment and low inflation through its monetary policy.
The central bank has a committee called the Federal Open Market Committee (FOMC) that meets periodically during the year (typically every five to eight weeks) to set the two key interest rates and establish its monetary policy. The FOMC is comprised of the seven members of the Board of Governors and five Reserve Bank Presidents. The committee reviews the preceding months' economic data for clues on the future and present health of the economy. The committee will act preemptively after reviewing the economic data. If they believe the economy is growing above their target range and creating inflation pressures, the committee may elect to raise interest rates to slow economic growth. Conversely, if they believe the economy is heading into a recession, they may lower rates to stimulate economic growth. Any time inflation is growing faster than their target rate, they will most likely raise interest rates. Their other primary monetary policy tool is buying U.S securities that add reserves to the commercial banking systems or selling U.S. securities that withdraw reserves from the banking system.
Investors, lenders and borrowers through out the world keep a watchful eye on the Federal Reserve's policy. As economic indicators are released by the U.S. government and private researchers, Fed watchers attempt to anticipate the central banks next policy move. The following are some more closely watched economic indicators that give clues to the current and future domestic economic growth and inflation.
- Unemployment and Non-Farm Payroll -- Reported by the Department of Labor:
- An increase in unemployment and or an increase in non-farm payroll suggests a healthy or expanding economy. In this scenario, there may be increased pressures on wages as demand exceeds the supply of workers. An increase in wages has wide spread ramifications on the cost of goods and services, increasing inflationary pressures. Conversely, an decrease in unemployment and a decrease in non-farm pay suggests a contracting economy, thereby reducing inflation.
- Industrial Production -- Reported by the Commerce Department:
- The industrial production statistic reflects the output of the countries' factories, mines and manufactures. An increase in industrial production suggests demand for wholesale and retail goods are expanding and the economy is growing. As demand outstrips the supply of goods, prices may rise and inflation may rise as well.
- Housing Statistics:
- The government and housing trade associations release statistics on the real estate activity in the country. The statistics cover new home sales, existing home sales, housing starts, building permits and new constructions. The housing sector and its many support industries are a major, if not the largest, component of the economy. An increase in housing activity can lead to inflationary pressures.
- Producer Price Index (PPI) -- reported by the Commerce Department:
- The PPI shows the monthly changes in prices at the wholesale level. An increase in prices at the wholesale level is often passed on to consumers at the retail level, resulting in an increase in the inflation rate.
- Consumer Price Index (CPI) -- reported by the Commerce Department:
- The CPI reflects the monthly changes in prices at the retail level. An increase in prices at the retail level, is considered inflationary. A decrease in prices is considered deflationary.
- Consumer Credit -- reported by Commerce Department:
- The monthly statistic on the growth of consumer credit is the total aggregate amount of consumer debt, excluding housing. An increase suggests consumers are confident about their jobs and ability to repay debt over the ensuing months. Consumers use debt to buy goods and services, stimulating economic growth. Conversely, a decrease suggests consumers are scaling back debt and may postpone the purchase of goods and services, inhibiting economic growth.
- Gross Domestic Product (GDP) -- reported by the Commerce Department:
- The GDP reflects economic growth in the country. The report is released each quarter, but is revised several times after new economic data is released. A strong rise in economic growth sometimes suggests there may be inflationary pressures on the horizon. Conversely, a decline in economic growth is considered deflationary.
In conclusion, the Federal Reserve monitors the economy to assure there is full employment, low inflation and modest growth. Many economic indicators, some of which are mentioned above, are used by the Feds to gain clues on the future health of the economy. When the Federal Reserve believes there are compelling economic signals that may push the economy out of balance, they may raise or lower interest rates and/or add or withdraw reserves from the banking system as a preemptive corrective tool.
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