In this five part series explaining the current state of the economy with supporting data, part two is a discussion of the meaning and implications of Monetary Policy.

We’ve all heard the predictions of financial doom lately, including both financial institutions and, more recently, the automobile industry.

In an effort to add a note of reason to this conversation, this is Part II in a five part series where we will look at current economic data, with an explanation of what it may mean for the future. In part one we discussed Economic Cycle Momentum.

Now, we’ll look at monetary indicators.

PART II – MONETARY INDICATORS

After seeing that 2007 economic cycle momentum indicators predicted the current economic slowdown, now acknowledged as being a recession, we will examine monetary policy. As discussed previously, the economic cycle includes intervention from the Federal Reserve Bank both in easing interest rates when the economy slows down, and in tightening them when the economy heats up. We’ll look at the direction of short, intermediate and long term rates, and what they tell us about both the present and the future direction of economic activity.

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The mandate of the Federal Reserve Bank is twofold: one, full employment; and two, price stability. Price stability means that prices are not unduly affected by inflation, which causes higher prices, necessitating higher wages, and if continuing unchecked, both prices and wages tend to spiral upward. To control prices, the Fed can increase the short term interest rates banks pay to borrow money in order to keep a required percentage of their deposit in reserve. These reserves accommodate the money bank customers withdraw from their accounts.

When banks must pay higher reserve rates, they are more careful to control the amount they lend to businesses and consumers. To control the amount of these loans, they charge higher rates, making the loans less attractive to borrowers. With slower borrowing, businesses lessen expansion and hiring, and consumers lessen their discretionary purchases. This set of actions tends to slow the economy.

Remember, though, that price stability is only one of the Fed’s mandates. The other is full employment. As interest rates increase and the economy slows, unemployment rates tend to increase. At the point where inflationary pressures have eased, the Fed will begin to lower these short term interest rates to stimulate the economy. Banks will increase lending; businesses will expand and increase hiring, thus decreasing unemployment rates.

We will look at three types of rates that reflect Fed monetary policy in this discussion – the six month Treasury bill, the ten year Treasury note and the thirty year Treasury bond.