Has the Federal Reserve’s Unemployment Threshold Become Irrelevant?

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Source: Thinkstock

Source: Thinkstock

Historically, the U.S. Federal Reserve has had one primary tool it reached for when it needed to edit the monetary environment. That tool is the raising or lowering of the target federal funds rate, which is the interest rate at which banks will trade federal funds.

This rate serves as a benchmark for most other interest rates throughout the financial market. When it is lowered, interest rates in general tend to decrease; when it is raised, interest rates tend to increase. Low interest rates help stimulate economic activity by encouraging borrowing and spending, as businesses can more easily access credit to buy capital or expand payrolls, and consumers can access cheaper loans for automobiles or home purchases. Higher interest rates tend to have the opposite effect, restricting the flow of credit by increasing its price.

This tool, simple as it may seem at first glance, is enormously powerful. In many ways, interest rates are the beating heart of the financial sector, and the Fed has its hand wrapped tightly around the muscle. The federal funds rate in particular can be used as a liquidity throttle. This is why in 2008, as the financial crisis wreaked wanton destruction through the banking system and credit markets began to seize, the Fed slashed the federal funds rate to the zero bound, hoping to stimulate business activity in interest rate sensitive sectors.

The strategy has worked, to a degree. Monetary policymakers have argued that although the economic recovery has been weak over the past few years, the only reason there is a recovery at all is because of accommodative monetary policy. Perhaps most importantly, interest rates have helped fuel the recovery of the housing market, which has been a cornerstone of the overall economic recovery.

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