Question

In mid-2017, an article in the Wall Street Journal noted that "the Federal Reserve's interest-rate increases aren't having the desired effect of cooling off Wall Street's hot streak where stocks have rallied to records this year." Is cooling off rapid increases in stock prices part of the Fed's dual mandate? Are such increases a concern for the Fed? Briefly explain.

Short answer

No, cooling off rapid increases in stock prices is not part of the Fed's dual mandate. However, such increases can be a concern for the Fed as they could indicate potential economic instability, which could in turn affect its dual goals of stable prices and maximum employment.

Step-by-step solution

Understand the Federal Reserve's mandate

The Federal Reserve operates with a dual mandate - to manage inflation (stable prices) and to promote maximum employment. The mandate does not directly involve the monitoring or regulation of fluctuating stock prices. Hence, 'cooling off rapid increases in stock prices' is not explicitly within the Fed's dual mandate.

Evaluate the relationship between interest rates and stocks

However, the operations of the Federal Reserve often indirectly affect stock prices. For instance, increasing the interest rate usually results in less borrowing due to the higher cost of loans. This can lead to a slowdown in business growth and subsequently affect stock prices. Therefore, the Fed's interest rate policies do indirectly influence the stock market.

Determine the Fed's concern for increasing stock prices

Even though it's not within their direct mandate, the Federal Reserve does monitor the stock market closely. Rapidly increasing stock prices could indicate potential economic issues such as asset bubbles. If these bubbles burst, it could lead to economic instability and consequently affect the Fed's dual goals of stable prices and maximum employment. Therefore, such rapid increases can be a concern for the Fed.

Key concepts

Interest Rate Policy

Interest rate policy is one of the primary tools used by the Federal Reserve to influence the economy. The Federal Reserve, often referred to as the Fed, adjusts these rates to either encourage borrowing and spending or to curb inflation.
This action falls under its dual mandate to ensure price stability and maximize employment. When the Fed raises interest rates, it becomes more expensive for businesses and consumers to borrow money. This typically slows down economic activity, reducing inflationary pressures.
On the flip side, by lowering interest rates, the Fed makes borrowing cheaper, which can boost economic activity and reduce unemployment but may risk higher inflation.

• Higher Interest Rates: Aim to control inflation by making borrowing costly, which slows down spending.
• Lower Interest Rates: Stimulate economic growth and employment by making loans more affordable.

Understanding the dynamics of interest rate policy helps to see how the Fed influences economic trends without directly controlling specific sectors like the stock market.

Stock Market Influence

Though not part of the Federal Reserve's dual mandate, the stock market is significantly influenced by interest rate policy. Changes in interest rates affect investor confidence and corporate profitability, leading to shifts in stock market prices. When the Fed increases rates, stocks may become less attractive for several reasons. Companies face higher borrowing costs, which can reduce profits and slow expansion.
In contrast, falling interest rates can lead to a rise in stock prices due to cheaper borrowing costs and more disposable income for investors. Besides impacting company earnings, interest rates influence investor behavior, as higher rates offer better returns on savings.

• Higher interest rates can lead to a drop in stock prices as borrowing costs rise.
• Lower interest rates often boost stock prices due to reduced costs and increased consumer spending.

This complex relationship highlights why the Fed's policies, although not directly aimed at the stock market, play a critical role in its performance.

Economic Stability

Achieving economic stability is a cornerstone objective that the Federal Reserve pursues through its dual mandate. By managing inflation and employment, the Fed seeks to create a stable economic environment in which businesses and individuals can thrive.
Rapid increases in stock prices, while not directly in the Fed's mandate, can signal underlying economic imbalances like asset bubbles. Such bubbles pose a threat to economic stability, as their eventual burst can lead to severe market corrections and financial crises.

• The Fed monitors asset bubbles because they can negate the goals of price stability and full employment.
• Economic stability ensures a predictable environment for investment and growth, benefiting society at large.

Thus, while the Fed's primary tools aim at inflation and employment, its oversight of the stock market helps in preemptively addressing threats to broader economic stability.