South-Western College Publishing - Economics  
FOMC on the horns of a dilemma
Topic Monetary Policy
Key Words Interest Rates, Economic Growth and Monetary Policy
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Reference ID: A147030687

News Story When Federal Reserve officials make monetary policy, they consider two primary goals. Their mandate compels them to promote maximum sustainable output and employment; at the same time, they must promote stable prices. Congress prescribed these goals in 1977 in an amendment to the Federal Reserve Act, and the Fed has had to act accordingly since then.

Current economic activity indicates that output and employment may be slowing at the same time that inflation is increasing at an unacceptably high rate from the Fed's point of view. The Fed consults the Beige Book, their report on current economic conditions published eight times each year, to gauge economic conditions. The various Fed districts contribute data to the Beige Book as part of the Federal Open Market Committee's preparations for its meetings.

Fed officials become especially concerned when inflation rises faster than 3 percent per year, and central bank officials have clearly indicated that they consider inflation the bigger threat. President of the Dallas Federal Reserve Bank Richard W. Fisher has described current inflationary pressures as "corrosive and discomforting." Susan Schmidt Bies, a Federal Reserve governor, said present inflation numbers are running at a level that "made her uncomfortable".

Ethan Harris, chief United States economist for Lehman Brothers, described the current economic situation as a mild form of "stagflation." Stagflation is a term used by economist to describe the twin economic problems of slowing economic growth and inflation occurring at the same time. Harris said, "I think the Beige Book was a pretty faithful mirror on what we pretty much already know, which is that the economy is slowing a bit, but it's not nearly enough to stop the pressures of inflation."

The Beige Book reported that consumer spending had continued to rise but showed signs of moderating as gas prices put pressure on spending for other goods. As more consumer dollars are diverted from manufactured items and services to gasoline purchases, employment and output in those affected industries will slow.

As these two issues of increasing prices and slowing growth compete for the Fed's attention, the Fed's job of stabilizing output and promoting price stability will depend in large part on how Fed analysts interpret the data. If the Fed responds to the inflationary pressure by increasing interest rates again, it risks slowing the economy even farther, and therein lies their dilemma. If the Fed does not raise rates, inflation may again take hold.

Discussion Questions:
1. Use any source available to research and write a short description of the activities of the Federal Open Market Committee. Who sits on the FOMC?
2. Discuss the dilemma of the Fed as suggested by the article. Which issue do you see as more pressing on the U.S. economy?
Multiple Choice/True False Questions:
1. Which of the following most closely describe stagflation?
  1. Prices are falling while economic growth is rising.
  2. Employment is increasing along with economic growth.
  3. Prices are rising while economic growth is falling.
  4. The annual inflation rate is up but the last quarter's rate is down.
2. If monetary policy increases the interest rate,
  1. inflation is likely to moderate.
  2. economic growth is likely to improve.
  3. inflation is likely to get worse.
  4. none of the above.
Source Jeremy W. Peters, "Fed's Dilemma: Prices Climb as Economic Growth Slows", The New York Times Online, June 15, 2006.
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