The Little Book of Economics: How the Economy Works in the Real World, Revised and Updated

Chapter Eleven

White Smoke over the Washington Mall

The Making of Monetary Policy and the Fine Art of Fed Watching

More than almost any other event on the economic calendar, meetings of the Federal Open Market Committee (FOMC) have the potential to rattle the markets. No wonder, then, that they are so closely watched.

One of those meetings was scheduled to wrap up December 16, 2008. The financial crisis was still raging and the economy deep in recession. The news that morning was particularly bad: Housing construction had fallen to an all-time low and consumer prices were flirting with deflation. The news investors most wanted, though, was what would the Federal Reserve do about this sorry picture? That afternoon, they got their answer: pretty much everything. The Fed announced it would “employ all available tools” to revive the economy: It cut its main interest rate from 1 percent to nearly zero; committed to keeping it there for “some time”; promised to buy truckloads of mortgage-backed bonds; and said Treasury bonds could be next. The announcement hit markets like a bolt of lightning. The stock market rocketed higher, while bond yields and the dollar plummeted.

That day illustrated several important things about monetary policy. It affects the economic outlook like nothing else can. It takes many shapes, from changing interest rates and verbal nods to purchases of all sorts of bonds. And for all its potency, it may not be enough.

Inside the FOMC Meeting

For all their market-moving ...