Tracing The Effects of Fed Policy

This Wednesday, US Federal Reserve Chairman Ben Bernanke will hold the first-ever press conference after the two-day policy meeting of the FOMC and the release of the Fed's Q2 economic forecast. The FOMC meeting minutes discuss Fed open market operations (sales of securities and foreign currency operations). The intent of the open market operations is to influence interest rates, money supply and the value of the dollar. Ultimately, the Fed is charged with fostering price stability, promoting sustainable growth in output and employment.

Below is a simple directed graph you can use to follow and evaluate Fed Policy (the symbols in the graph are defined below).

Fed manipulation of interest rates is clearly designed to increase investment. An increase in investment will increase national income and increase employment. Increases in the money supply (access to credit) will, in addition to stimulating investment, also stimulate consumption (as long as banks are willing to lend).

A current controversy (here) involves whether the foreign currency operations are helping or hurting recovery. Since world commodities and the US stock market are denominated in dollars, decreases in the value of the dollar have contradictory effects, increasing exports and stock prices will decreasing consumption (increasing gas prices act like a consumption tax).

It will be an interesting press conference. The FOMC statement will be released at 12:30 pm ET Wednesday, market reaction will follow and the press conference will be held at 2:15 pm ET followed by the market close at 3 pm ET.

NOTE: The Fed economic projections are available in the html version of the FOMC Meeting notes (for example, see the Jan 25-26 2011 notes here and the summary of economic projections here). In the FOMC minutes, the Fed publishes projections for the change in real GDP, the unemployment rate, percentage changes for PCE inflation (the price index for personal consumption expenditures) and Core PCE inflation (the PCE excluding food and energy).

In the graphic, symbols are given conventional definitions: i = interest rate, M = money supply, I = investment, G = government expenditure, C = consumption, X = exports, IM = imports, Y = aggregate demand and L = employment.