Monetary Policy from 1999 to 2005

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Here is a brief summary of the target federal funds rate over the period from June 1999 to May 2005. Remember that these are nominal interest rates.

We have already examined these targets, together with the actual federal funds rates, in***Figure 10.3 "Target and Actual Federal Funds Rate, 1971–2005".

The time of tighter monetary policy, from June 1999 to January 2001, was a period of inflation concern. In the first part of 1999, the inflation rate averaged about 2 percent, and the unemployment rate was decreasing, reaching 4 percent in May 1999. Even though inflation was low, the Federal Open Market Committee (FOMC) statement from June 1999 called for an increase in the target federal funds rate, pointing to potential inflation as a rationale for increasing the target rate: “The Committee, nonetheless, recognizes that in the current dynamic environment it must be especially alert to the emergence, or potential emergence, of inflationary forces that could undermine economic growth.” [***Federal Open Market Committee, “Press Release,” Federal Reserve, June 30, 1999, accessed August 8, 2011,http://www.federalreserve.gov/boarddocs/press/general/1999/19990630/default.htm.***] The Fed’s tightening had the effect of reducing durable spending and thus bringing gross domestic product (GDP) down closer to potential output. As a consequence, there was less pressure on prices.

This policy continued through January 2001. By that point, the United States was very close to recession. (According to the National Bureau of Economic Research Business Cycle dating group, a recession began in March 2001.) From December 2000 to January 2001, the unemployment rate jumped from 3.7 percent to 4.7 percent. The Fed responded by allowing the federal funds rate to decrease steadily, starting in February 2001. This policy led to a federal funds rate of 1 percent by July 2003, a level that was maintained for a year. Historically, this was a very low rate. Over the year, inflation averaged about 2.3 percent, so the real federal funds rate was actually negative.

A turnaround in Fed policy occurred in August 2004. Inflation had started to increase somewhat in early 2004, and the unemployment rate had decreased to 5.3 percent in May 2004. So in August 2004, the Fed started a gradual increase of the target federal funds rate. Look back at Figure 10.4 "Short-Term and Long-Term Interest Rates". Recall that part of the monetary transmission mechanism is the link between the nominal federal funds rate, which is very short term, and much longer-term rates. Figure 10.4 "Short-Term and Long-Term Interest Rates" shows the federal funds rate along with the 1-year and 10-year Treasury bond yields. The loosening of monetary policy in February 2001 is evident from the decrease in the federal funds rate and the 1-year Treasury rate.

But the long-term Treasury rate seems not to follow the short-term rates that closely. In fact, it seems that the long-term rates started to decrease before the reductions in the federal funds rate began, and then the long-term rates did not decrease nearly as much over the February 2001–August 2004 period. After that time, although the federal funds rate was increased, the long-term rate did not respond much at all.

This reminds us of one the biggest challenges of monetary policy. Although the Fed is able to closely target the federal funds rate, it has much less ability to control longer-term rates. Someone making a loan for a long period of time will try to anticipate economic events over the course of the entire loan period. As a consequence, the loan rate may reflect anticipated events (such as the Fed’s loosening of monetary policy in February 2001) and may also not respond as much to rate changes that are seen as temporary.