QUESTION 1: Name: Derek M Grubbs Student ID: 44055574 The two objectives of the FOMC are to maximum employment and price stability. With the inflation at around 2% and the latest unemployment rate being 5.9%, it is time for the Fed to start to return the monetary policy back to normal.

In September of 2012, Fed chair Ben Bernanke announced an indefinite program of $40bn per month in asset purchases. Some feared this quantitative easing would never come to an end. However, under new chair, the Fed plans to stop quantitative easing. The Fed’s balance sheet is around 4.4 trillion, up from 900 billion before the crisis; this was caused by the bond purchasing . At this point in the economic recovery, the growth and job creation has some momentum, which can be expected to continue without this stimulus. The issue with this monetary policy is that it may in fact be creating asset bubbles similar to those that contributed to the financial crisis. Investors search for returns, and the Fed's super low interest rate policy may have caused them to become so crazy making investmenst that aren't actually portraying the true value of these various investments. What this means is, due to the low interest rates, investments are being made not properly accounting for the risk, only because the borrowing rate is so low. The Fed’s goal in injecting this money into the economy was to try and push asset prices up, ie. Fight deflation.

While the Fed may have achieved their goal to stimulate borrowing capacity for growing businesses to improve the economy, it now needs to try and stabilize what seems to be an extended amount of time at the zero interest rate policy. I believe the FOMC should lay out a plan to reduce quantitative easing and slowly raise the interest rates. They will have to make sure financial institutions are capitalized well enough to sustain any bubble bursting that may occur. Their goal should not be to ensure there is no bubble, or bubble popping, however they should just ensure the institutions are ready for the worst case scenarios moving forward.

To raise the Federal Funds Rate; they should not just look at unemployment. They should discuss exactly what needs to exist before raising the rates, things like: inflation indications, expectations, financial conditions, and overall labor market conditions.

I believe the FOMC should do things at a slow and steady pace. The quantitative easing reduction of $10bn per month which leads to its end around the end of 2014. Currently Yellen suggests approximately six months after this end, they will start to increase interest rates. While the Fed could use the 2004-­‐2006 timeline for raising interest rates; I do not believe that to be the best case scenario. I think the FOMC should not provide a timeline for when the rates will be increased until after they are able to fully grasp how the economy reacts once the asset purchases reach zero.

Some to believe the Fed should shorten the timeline for reducing the stimulus program because the economic recovery has been sustaining a bit lately. The Fed must remain cautious as to not be the reason for another economic recession; therefore it should be careful about reacting too quickly and not staying on path.

While the FOMC is not tied to the decisions of its predecessors; those decisions were made and have re-­‐shaped the economy in ways that we can't fully understand because the data just doesnt exist to analyse, in terms of undoing those actions. You can see the uncertainty in the markets just by observing the changes in the the S&P 500 stock index when Ms. Yellen talks about their plans for interest rates. Everyone's massive analysis and speculation of what she is saying that the market fell sharply, then rose sharply, then leveled off. This should be an indication of the importance as to how we decide to raise rates.

The Fed must tread cautiously because if they push too hard, unsustainable growth could eventually generate faster inflation; whereas if it stops pushing too soon, they could lose out on potential economic repair that the stimulus would have provided.

The FOMC’s old group has put Ms. Yellen in a troublesome spot. Critics have warned that the Fed was doing too much, which may in fact be the case, however, to just pull out the stimulus program all together at a fast pace could unravel what little bit of good it may have done.

There are potential negative consequences of pushing for inflation. With a 2% inflation year over year; in twenty years, it will take $150 to purchase the same good as it costs $100 to purchase today. Is devaluing the dollar a good thing? The Fed’s zero interest rate policy magnifies the negative consequences of the erosion of the dollar value. They essentially are giving negative returns on short-­‐term bonds and bank deposits. Essentially, the Fed is taking away value from the hard earned dollars that Americans have saved. After-­‐all, isn’t the Fed’s goal “price stability?” The issue is when inflation nears zero, deflation could exist causing no one to spend their money, therefore no economic growth (ie. they could buy the same thing tomorrow for less).

The Fed believes that the financial policies in place; ie. The zero interest rate policy, and controlling the value of the dollar (ie. 2% target inflation rate) can reduce the unemployment rates. However, some skeptics point to the results of the past 40yrs, and that not being the case. Some believe the financial crisis was cased in no small part by the Fed keeping interest rates too low, for way too long. The Quantitative Easing has also shown to not have done much to spur economic growth, in fact possibly reduced the growth. Before June 2011 and November 2011 the economic growth was at 3.4% then slowed to 1% (this was when the Fed purchased $600bn in treasury securities, zero interest rates, and injecting banking systems with reserves). Once the Fed stopped supply of this liquidity, the second half of the year economic growth went up to 2.3%.

A lot of this data helps support my stance that the Fed definitely should cease the quantitative easing, as I do not think it has had the effect that was intended. One of the problems the Fed faces is when it makes these decisions, it is making them based on past data, and speculation of the future. They must consider sometimes, things are out of their control with respect to inflation. An example would be when there was a debt crisis in Europe leading to deposit shifting out of the Euro and into the dollar.

The fed is now under pressure of all the money it has put into circulation. When you stimulate the economy with so much money, you'd expect economic growth to catch up to consume that money; which hasnt necessarily happened as they expected; now they feel the best course of action is to try to push inflation up.

The yield curve is a reliable predictor of future real economic growth. It can provide analysis for the probability of a recession. Attached is the current probability chart: the model uses the difference between the 10yr and 3mo treasury rates to calculate the probability of a recession in the US, 12 months ahead. Currently the yield curve has been getting steeper, which means the probability of recession in the next 12 months is going down. However, the predicted GDP growth is approximately 1.5%. These are a couple things that you can use the yield curve to predict. So; while the GDP growth is slightly pessimistic, it is quite optimistic about the economic recovery continuing. You can use this to try and help what the FOMC should do with rates. If they tighten their monetary policy; short term rates will go up, but long term rates

don’t go up by the same level, therefore the yield curve is less steep indicating a slowdown in the economy, or even worse, the yield curve could invert which usually indicates a recession is coming. The issue with this is, the yield curve analysis only works when it is a market driven yield curve. Currently, we are in an intervention yield curve therefore it makes it difficult to predict anything using the current slope.

The role of banks with linkage to Fed’s actions is paramount. The interest rates that the Fed’s set is for the banks to borrow money. When the banks borrow at lower rates, they are able to offer lower rates to the consumers, therefore the theory is consumers will demand more loans and therefore spend more, or invest more in small businesses etc. This spending and investing into small businesses is what can drive economic growth; hence why the Fed believes keeping interest rates at zero for the time being is the best way to spur economic growth.

Certain conditions, outside of monetary policy, can exist that could cause interest rates to change. Basic supply and demand can change the interest rates. If demand for loans is high, the banks can charge a higher interest rate (which they need to do, as they have to have the money to be able to supply this demand, one way of doing that is to charge higher rates). If the demand for loans is low; this will lower rates as lenders will be competitive. Another factor is inflation; if inflation is high, and may go higher, then investors will require a higher interest rate to consider lending their money. This could potentially muddy the Fed’s exist strategy with regards to its current stimulus monetary policy. They are holding interest rates low; but if they

raise them and let them move with the economy, the potential exists for inflation to flatten out, possibly deflation, sending the interest rates low again.

To answer whether we will be zimbabwa or Japan; we will not "be" either. I believe that there are two things that could potentially come from the injection of money into the economy. When the Fed finishes the quantitative easing and decides to start raising interest rates again; I think that because the economy still isn't growing like they'd like, the raising of interest rates could cause even less spending than is currently happening, leaving potential for, at least short term, deflation or a very very low inflation. Long term, I think the obvious answer is that we'll be closer to a zimbabwain outcome in that inflation will, and almost has to, happen. They've injected so much money so quickly without really being able to comprehend the outcome years from now. They will obviously have the option to start cleaning up their balance sheets and absorbing some of the cash back from the economy, but with the way politics seem to influence the Fed's decisions, will they have the guts to actually do this? That is the big question in my mind and I look forward to seeing how things truly to turn out. Before this class I literally had no clue about any of these issues and the possible impact from a grand scale; but it is clear now that these are important issues to pay attention to. I believe Ms. Yellen has a tough road ahead of her, and it will be very interesting to see how it is handled.

External sources:

The Yield Curve as a Leading Indicator -­‐ Federal Reserve Bank ... (n.d.). Retrieved from http://www.ny.frb.org/research/capital_markets/ycfaq.html

Does the Affordable Care Act Make Businesses Less Likely to ... (n.d.). Retrieved from http://www.employmentcrossing.com/employers/article/900016633/Does-­‐the-­‐ Affordabl e-­‐Care-­‐Act-­‐Make-­‐Businesses-­‐Less-­‐Likely-­‐to-­‐Hire/ WTO cuts trade forecasts for 2014, 2015 -­‐ Xinhua | English ... (n.d.). Retrieved from http://news.xinhuanet.com/english/business/2014-­‐09/24/c_127024432.htm Why Do Interest Rates Change? -­‐ The Financial Pipeline. (n.d.). Retrieved from http://www.finpipe.com/why-­‐do-­‐interest-­‐rates-­‐change/ "The End of Quantitative Easing Is Good News." Washington Post. The Washington Post, July 2013. Web. 07 Oct. 2014. . Kaldec, Charles. "The Federal Reserve's Explicit Goal: Devalue The Dollar 33%." Forbes. Forbes Magazine, 6 Feb. 2012. Web. 07 Oct. 2014. .