1. Feras Zarea
Professor Veronika Dolar
Federal Research Paper
12/19/15
The United States’ economic activity has been soaring as of late. The numbers might not
be sky high, but they do indicate respectable signs of sustainable growth in the economy. While
this might be milder than previous recoveries have been, the numbers show that the economy has
nonetheless recovered. The most effective method to track an economy is to check its indicators
after they have been adjusted for inflation. Real GDP (Figure 1) has increased steadily over the
past 5 years. And since GDP is the chief indicator for judging an economy, we should segment it
to its components and see where the positives and negatives are; starting by consumption.
By looking at Figures 3 A and B, which depict the real personal consumption
expenditure, we can see real consumption in the economy. Consumption compiles roughly 2/3 of
GDP; making it the most important component. Prior to the 2008-2009 recession, also known as
“The Great Recession”, real consumption has increased steadily by 2% to 3.5%. However,
starting in mid-2007, the growth rate of consumption seemed to halt. And towards the end of
2008, consumption started falling, the growth rate reaching -2.4%. Thankfully, after the all-
decade-low of -2.67% in June 2009, consumption started increasing steadily again. And in 17
months, the percent growth of real consumption reached 3.23%. Real consumption has been
steadily increasing in the past 5 years, Real consumption increased from almost $10 trillion a
year to over $11.3 trillion in the past five years. In the time spanning March 2011- July 2015, the
growth rate stood between 1% and 3.7%. Moreover, starting in August 2014 and ending in
September 2015 consumption consistently increased by over 3%. Finally, the current problem is
that real consumption growth has, in accordance to the latest information dating October 2015,
fell under 3%.
The second component of Real GDP is Real Investment; depicted in Figure 4, titled
“Percentage Change in Real Gross Private Domestic Investment”. Investment is the most volatile
part of the GDP, meaning it’s the quickest to respond to economic shocks. Therefore, real
investment will aid us in tracking the economic conditions of the country. Investments
approached 5.7% in 2006. However, by 2007, they reached fell to -4.9%; and by 2009, fell to -
26.4%; falling from almost $2.7 trillion to $1.8 trillion. Such a regression is strikingly quick.
And it probably has a lot to do with the housing bubble bursting. But, in 2009, investments
started increasing exponentially, and within a year business investments increased by 47.5% to

2. 21.1% in 2010. And by 2012, the investment growth rate fell to the pre-recessionary levels. And
since Q4 2012, the percentage change has stood between 1.9% and 7.6%. However, while the
growth rate of investment has averaged 5.05% in the past 12 quarters, the real gross private
domestic investment only surpassed the pre-recessionary high of $2.77 trillion in Q4 of 2014;
with the most recent estimates putting it at $2.86 trillion.
The third component of GDP is government spending. Real Government spending
(adjusted for inflation) is depicted in Figure 5, labeled “Real Government Consumption
Expenditures and Gross Investment”. Government spending is different from consumption and
investment in that it largely maintained growth up until the end of recession, and only began to
decrease after the recession. In only 2 years, Q3 2005, till Q3 2009, real government spending
increased from $2.84 Trillion to $3.1 trillion; a growth ray that averages 4.55% per year. It was
not until Q3 2010 that government spending started dropping. And by the final quarter of 2013,
government spending was for the first time lower than the pre-recession low of $2.84 trillion.
Moreover, in the past 2 years (Q4 2013 – Q3 2015), Government spending has roughly averaged
2.843 trillion, roughly matching the pre-recession low of 2.84.
The final major component of GDP is the net exports in the United States. Net exports
(Figure 6) are typically negative, as the United States imports more than it exports. For the 5
quarters dating from Q3 2005 to Q3 2006, real net exports averaged -$799.88 billion. By looking
at their percentage changes (Figure 7), real imports and real exports have both trended through
similar paths. However, real imports fluctuated more than real exports. In Q1 2007, the growth
percentages of real imports and exports were 3.9% and 7.9% respectively. And real exports were
still increasing going into 2008. However, they both eventually crashed; and, in respect to their
decade-low growth rates, real imports fell by a larger margin. In Q2, 2009, real imports reached
negative 18.6%, while the real exports fell to minus 14%. This shows that the two growth rates
both respond to economic conditions in a similar manner. Such a statement is strengthened by
studying the similar rises they experienced in the next year; as, in Q3 2010, real imports and real
exports increased by 16.4% and 13.6% respectively. They started falling, however, and towards
the end of 2011, up until the latest quarter, the growth rate has been sitting between negative
0.1% and positive 6.5% for imports, and between positive 1.2% and 4.2% for real exports. Net
exports do show that the economy is stabilizing and recovering, as net exports are falling to pre-
recessionary levels.
In order to indicate how the changes in the economy are affecting the consumer, we
should look at the GDP per capita (Figures 2 A and B). From 2005 to 2008, GDP per capita has
fallen by 3 percent. However, starting mid-2007, it fell by roughly 6%, meaning the average
person’s income fell by over $2,000 a year. GDP per capita, however, started increasing towards
the end of the recession (almost 7% in less than a year), and currently stands at $51,018; the 10-
year low was $46,781. Moreover, by averaging the per capita growth of the past 20 quarters (Q3
2010-Q3 2015), we can see that GDP per capita has increased by 1.36%.
By looking at the components of GDP, we can see that the economy is growing.
However, there is a limit to what GDP, on its own, can explain to us. And there are many other
indicators that must be analyzed to envision what direction the economy will walk through and
what caused previous shocks in the economy. And a good way to understand how individuals are
functioning is by looking at the labor force; specifically the unemployment in the economy. The
labor market is where those who look for jobs interact with those who are offering ones The

3. main two indicators looked at for analyzing unemployment are The U3 rate, gives us a good
indication of how the labor force is doing, and the U6 rate, which helps us understand the
efficiency of those employed. One of the Federal Reserve’s dual mandates is to achieve
maximum employment; therefore, tracking the unemployment rate is integral.
Figure 8 displays both the U3 and U6 unemployment rates in the country. The U3 rate is
the officially accepted unemployment rate. And in the years preceding the recession, the U3
unemployment rate sat in the 4.5% to 5% range; while the U6 rate, which includes part-time and
discouraged workers, sat between 7.9% and 8.4%. However, in December, both the U3 and U6
unemployment rates started increasing. And, in June 2009, the end of the recession, the U3 and
U6 unemployment rates increased to 9.5% and 16.5% respectively. Over the years dated 2009-
2011, the unemployment rate averaged the highest pace of the recorded data; with the U6 rate
staying over 15% and the U3 rate approaching 10% unemployment. Luckily, both rates gradually
started falling, and the U3 unemployment rate is back to the 5% range of natural employment.
The U6 rate, however, still stands above the pre-recessionary levels; and is currently almost
10%. Figure 8 demonstrates that the gap between the U3 unemployment rate and the U6
unemployment rate is larger than it previously was. And the high U6 rate indicated that the
efficiency of workers is lower than it could be in the economy. Moreover, even though the U3
unemployment rate is low, we should look at the labor force participation rate to better
comprehend why the unemployment rate is low.
Prior to the recession, the Labor Force Participation Rate (Figure 9) was sitting near 66%;
and this continued through the first recessionary year. However, starting in October 2008, the
labor force participation rate started falling. And, disregarding few minor surges, the labor force
has been shrinking ever since. Additionally, within 7 years (Oct 2008-Nov2015), the labor force
participation rate has fallen by 3.5%. And this shows that the low unemployment rate could is in
part due to individuals leaving the workforce. The lower participation rate does show that
discouraged workers are, in fact leaving the workforce, thereby increasing the U6 rate. We must
understand, though, why workers are leaving the labor force, as they might not be as a result of a
bad economy.
According to John C Williams, the president of the San Francisco Federal Reserve, the
reasons the labor force participation rate is going down could be due to baby boomers retiring
and people living longer. The participation rate counts everyone older than 16, and millennials
prefer extending their education instead of working. Williams adds that those who were working
are returning back to school.
Falling oil prices should be noted too when analyzing what the Fed’s next move should
be, as the prices have a positive impact on American consumers; making them feel richer. Saving
on the price of filling up their cars leads to consumers feeling richer; as they will be able to make
more purchases with their same salary; leading to consumer confidence rising. This will lead to
more consumption. And the high consumption rate is a motivating force for business investments
to increases too and, therefore, two main components of GDP; consumption and investment, both
increase.
Figures 10 A and B show the price of oil in the past 10 years. Oil prices have fluctuated
heavily in the past decade. And in the years prior to the Great Recession, crude oil prices have
maintained a price of $58-$75 per barrel. However, in January 2007, when oil prices reached
their lowest point of the pre-recessionary period at $58.17 per barrel, prices started surging. And

4. 18 months later, in July 2008, oil prices reached an all-decade high price of $139.96 per barrel.
This means that the spike in the prices of oil, which occurred in only 18 months, totaled a 140%
increase in price increase. And as a result inflation’s dependability on the price of oil, the CPI
year over year (YoY) percentage increase (Figure 11) raised from 1.4% in Oct, 2006, to 5.5% in
July 2008; with the YoY percent increase in the price of oil increasing by 96% in comparison to
the January 2007 rate of -12.67%. However, after that large spike in oil prices, in mid-2008, at
the height of the recession, crude oil prices crashed down. And in only 6 months, in January
2009, oil prices fell to almost 41.73$ (-56.6%). Such a low oil price was short lived, though, as
roughly a year later, the first quarter of 2010, the price of oil exceeded $70. And in April of
2011, oil prices reached a post-recession high of $113; 40% higher than the already high
previous year. In the three year span of June 2011 – June 2014, crude oil prices fluctuated in the
unusually high $80-$120 per barrel range. However, oil prices crashed again; and in January
2015, oil prices fell to $47.79; a 60% decline from the previous year. And in the past year, oil
prices fell even further; currently at an all-decade-low of only $37.64.
What must be of note for the Federal Reserve is that it does not seem as though oil prices
will increase soon. Reasons for such an assumption include what is occurring with oil suppliers.
The Organization of the Petroleum Exporting Countries, also known as OPEC, has ultimately
functioned as a cartel for the past few decades. And OPEC does not want to cut the supply of
Crude Oil; which they usually do in order to raise prices. Among the reasons for keeping prices
low is to make an emerging supplying competitor’s method, oil fracking, unprofitable and drive
its companies out of business. In addition to the trade bans finally being lifted from Iran, thereby
introducing a new worldwide oil supplier. However, other main reasons for not cutting the
supply of oil are political, and they currently do not serve to aid the Fed in making a decision
affecting monetary policy. Therefore, we will not delve into details regarding them.
The effects of falling oil prices on the US economy are mostly positive. A drop in falling
oil prices leads to business investments increasing; which means GDP increases. Moreover,
adding investments leads to higher employment. Additionally, even though falling oil prices can
be terrible for some American businesses, such as the aforementioned oil frackers, they are
mostly positive for the economy; as the US tends to import much more oil than it exports. There
is major problem caused by falling oil prices that affects the US economy however, as the
inflation rate will fall. And inflation is already extremely low, averaging an almost zero percent
change from last year. In a formulaic view, falling oil prices equal falling inflation. And such
low prices mean we run a true risk of deflation; as we are already facing severe disinflation.
The second part of the Federal Reserve’s (Fed) dual mandate is inflation. And the most
commonly used method to measure inflation is the Consumer Price Index (CPI), exhibited in
Figure 11. The CPI mixes a basket of goods commonly purchased by consumers and compares
the prices to a base year. There are two main CPI indicators used, “all items”, and “all items less
food and energy”; also known as core prices. The measurement of core prices is used as a result
of the rapid-fire fluctuations in the price of oil and food product. Starting by the core CPI, we can
see that, for the years 2006-mid-2008, core CPI has maintained a growth rate of 2-3%. However,
in the middle of the recession (end of 2008), we can see that the core CPI dropped to below 2%.
And by 2011, it fell to less than 1%. Thankfully, quickly after that 10-year low, core CPI
increased over 2% in mid-2011. In the four to five years since, core CPI has been averaging just
under a 2 percent rate. The CPI that includes food and energy, however, has fluctuated much
more drastically. And by comparing it with the price of oil, shown in Figures 10 A and B, we can

5. see that crude oil prices play a major role in order to shape the CPI; thereby oil plays a large part
in shaping the inflation rate; Meaning that falling oil prices can play a big part in the economy.
There are many good indicators we can examine in order to understand the economy.
And even though we have discussed the main ones, the GDP, the inflation rate, and the
unemployment rate, it is much more helpful to analyze different data in order to assess the
direction of these main indicators; starting with consumer confidence.
The widely used tracker of consumer confidence is the Michigan Consumer Sentiment
Index which can be seen in Figure 12. As a result of it being an index, the actual number is not as
important as how the numbers have been changing. Prior to the recession, the Michigan
sentiment has fluctuated in the 70 to 100 range. However, starting in mid-2007, right before the
recession, the index started free falling; much like most other market trackers. And in less than 2
years, the index fell from being close to 100 to becoming under than 60. This meant consumer
confidence fell heavily; and as a result, consumption fell similarly. If we look at the percent
change of Real Personal Consumption Expenditures (Figure 3), we can see that the drop in
consumer confidence in 2007-2008 led to a similar fall in consumption; and lest we not forget
that consumption makes up 2/3 of the GDP. Moreover, the recovery of consumer confidence
also paralleled that of consumption; and, after the Michigan Sentiment fluctuated in the 55-72
point range in the 2008-2009 recessionary years, the consumer confidence increased again. And
in mid-2009 to mid-2011, Figure 12 shows that the sentiment was averaging the 65-75 range.
And, since the 10 year mid-2011 low, which was said to be caused by low employment numbers,
the Michigan sentiment has continually increased; currently residing in the 90+ average again.
The high current consumer confidence is most likely directly related to us being near maximum
employment; and it aids with the stable increase in consumer spending.
Inflationary expectations are also tracked by the University of Michigan (Figure 13).
However, they are not as positive as the consumer confidence is. Inflationary expectations
respond quickly to changes in the market; thereby they tend to fluctuate heavily. And the heavy
fluctuations of the inflationary expectations make them difficult analyze. However, they do
provide a good outline for where the price level is expected to be. Moreover, inflationary
expectations help households and firms to understand when they should spend money or save
money. The problem with low inflationary expectations is that people will always think that
waiting to spend at a later date, where prices will be lower, is better. This, in turn, discourages
market activity and leads to complications in the industry. Prior to the recession, inflationary
expectations have been relatively constant; ranging between 3-4%. However, inflationary
expectations rose from by 1.4% from January 2008 - to May 2008 (from 3.4% to 5.2%). such
high expectations were short-lived however, as, by December; expectations quickly fell to 1.4%.
But the expectations recovered before there were deflationary expectations, and from May 2009
to December 2010, inflationary expectations ranged from 2-3%. Moreover, expectations rose
from 2.2% in September 2010 to 4.6% in March 2011. However, this was short lived, as, by July
2011, inflationary expectations fell to 3.4%. And from August 2011 till August 2014,
inflationary expectations ranged between 2.9% and 3.9%. Moreover, in the past year,
inflationary expectations fell again, and have been standing from 2.5% and 3.5%. Finally,
inflationary expectations currently lie at 2.7%; and the past year involved the lowest expectations
since 2010. The current 2.7%, coupled with the low oil prices, means that deflation is a looming
threat.

6. Another good reference for the performance of the US economy is that of the U.S dollar.
By referencing Figure 14 (the U.S. Dollar Index), we can see that the dollar constantly fluctuated
from 2007-2010. It can be seen that, in the first quarter of 2007, the value of U.S. dollar started
depreciating from the index that was averaging the 80s. The weaker USD means that imports
will fall and exports will rise; leading to net exports rising. The U.S Dollar continued to
depreciate till the third quarter of 2008; when the index point was almost 70. The USD, however,
started appreciating, in July 2008, going back to the 80s by November. In Q2 2009, however, the
dollar again began to depreciate again; reaching the low 70s again by the end of 2009. After the
dollar fluctuated a bit more in 2010, 2011 marked the only time in the decade where the index
fell below 70. The index did start rising gradually, and in 2013-14, it scored index points ranging
75-80 points. In Q3 2014, however, the dollar appreciated severely, most likely as a result of oil
prices plummeting. And since February of 2015, the dollar value has been as ranging from 85-
95; meaning the dollar is appreciating extremely highly. The currently appreciating dollar means
that the U.S. will import more than it exports, and signals to the economy going back to how it
used to be previously.
Before we discuss what the Fed’s options are, we should mention what was occurring
during the recession that led to setbacks in the economy, starting by the housing bubble. The
housing bubble is agreed upon as one of the main reasons the US economy fell into recession.
The cause of the bubble is the fact that banks. These banks securitized mortgages combined
them. And traded them, which essentially means they put dollar values on mortgage loans, and
sold them. The problem was that over time, these loans became riskier, as they were given to
people with bad credit; and these high-risk mortgages are known as “subprime”. The banks
offered different ways to entice borrowers, such as “teaser rates”. And the banks sold these
securities to investors expecting less risky behavior from the borrowers. A major problem was
that the credit agencies who assign grades to different mortgages based on riskiness were not
practicing their moral rights of making sure the mortgages deserve their high ratings; while the
regulators were not efficient enough in stopping them. The reason these banks were not worried
over the repayment of debt is that they expected the large growth rate of real estate prices will
continue. Moreover, these large scale banks, such as Lehman Brothers, American International
Group (AIG) and Bear Stearns tied themselves to real estate prices. The problem, though, was
that housing prices rose quicker than inflation and incomes. And the bubble finally burst. This
lead to people being forced to default on their mortgage rates; which lead to the banks not having
liquidity, putting them in grave danger.
As a result of these large investment firms attaching themselves to real estate prices, the
stock market collapsed; as evidenced by Figure 15. In July 2007, the stock market started falling,
and over a year later, in October 2008, it fell by almost 40%; driving the great recession. After
many different institutions failed, leading to people losing their jobs and most likely their
savings, a recovery insured. The Federal Reserve tried everything they could to correct the
market; such as influencing the decrease of the Federal Funds Rate (Figure 16). In 2007, the
Federal Funds Rate was over 5%. However, the Fed decided that they must decrease it, and they
bought enough short-term bonds that the Federal Funds Rate (FFR) dropped to almost 0% in just
over a year (by Dec 2008). And even though they committed an act drastic enough to wipe out
all its traditional powers, they realized that it was not enough. And the Fed understood that it
must now try some non-traditional methods of increasing the money supply; thus the idea of
quantitative easing (QE) was born.

7. The Federal Reserve decided that they must go through all means to stimulate the
economy to keep with their dual mandate of keeping prices stable and employment at a
maximum; and initiated QE. In short, the Fed decided to buy mortgages (bad securities) to lower
the interest on them, And to buy long-term government treasury bonds (they usually buy short
term). By doing so, the Fed’s goal was to decrease long term interest rates and to increase asset
prices, leading to those affected by the assets to feel richer (wealth effect). This wealth effect
leads to both consumption and investment to increase, and therefore aggregate demand (GDP)
increases. The U.S. treasury department was forced bailed out large companies that they deemed
“Too Big to Fail (TBTF)”. And if they did not bail them out, the belief is that the failure of such
large institutions would have been cataclysmic for the economy. Another major reason for the
current sustainability of the economy is the many regulations added as a result of the risky
behavior of these investment firms; such as the “Dodd-Frank Wall Street Reform and Consumer
Protection Act”, which was passed in 2010 in order to lower risk by restricting and regulating
bank investments.
Moving towards 2016, the Fed has a big decision to make. “Should the FOMC increase
the interest rates?” is a question everyone is asking; as the Federal Open Market Committee
(FOMC) has not increased the rates since they dropped them in 2008-2009. Low interest rates
mean there is not much lending occurring in the economy. However, before the FOMC decides
on what they must do in the next meeting (in only a few days), we must understand what
difficulties the economy is facing. A recap of economic conditions shows that Real GDP has
been increasing by 2-3% in the past 2 years. GDP’s components are also shifting back to their
desired numbers, with real domestic investment and real consumption rising, Government
spending declining, and real net exports falling (signals of a booming period). Moreover, in order
to focus on the dual mandate, we must look at the unemployment rate and the inflation rate. the
unemployment rate is near the natural level of 5%; albeit the U6 rate is still high, meaning both
that there are more discouraged workers in the country than would be liked, and employees are
not being used to their full abilities. Additionally, the inflation rate is extremely flat and
inflationary expectations are low; as the economy is moving from the current state of disinflation
to the looming threat of deflation. Consumer confidence is high; and the stock market is
booming; with the federal funds rate being near 0%. Finally, negative foreign indicators, such as
China’s sluggish growth, and the deadly Paris attacks, discouraged the FOMC from increasing
the interest rates in the past meeting.
Approaching the next meeting, the FOMC has two traditional options: with the third
traditional method being impossible at the current rate. The impossible option that the Fed
normally had at their disposal would have been to lower the interest rates. However, as a result
of the Federal Funds Rate residing near the zero-lower-bound for the past 6 years (Figure 16),
that is not currently an option. The extremely low interest rates mean that the Fed is left with two
options. The first option is to keep the interest rate at its current “zero-lower-bound” rate. That
will mean that the inflation rate will fall further as a result of oil still prices still declining.
Keeping the rates also means that there will be low output growth and almost maximum
employment of those in the U3 rate. If the FOMC, however, decides to engage in contractionary
monetary policy; which means to decrease monetary supply by increasing the Required Reserve
Ratio, the Discount Rate, and/or by selling short-term Treasury-bills.

8. We believe that the FOMC must increase interest rates. And, they should do so by engaging in
“Contractionary Monetary Policy”. They decrease the monetary supply by increasing the
Reserve Requirement Ratio (RRR), the discount rate, and/or by selling T-bills. Increasing the
reserve ratio is not a good option, though, as banks are not leveraging in high risk measures
anymore. Even though Contractionary Monetary Policy will decrease investments (interest rates
and investments are inversely related), increase the unemployment rate, and further risk
deflation, there must come a time when the country actually raises rates in order to better prepare
us for future uncontrollable negative shocks. The FOMC engaging in the contractionary policy
might be a negative shock, but at least it would be controllable. And we must raise the interest
rates now, at a time of stability. The unemployment rate is currently low enough for the
contraction of the economy to not be extreme. Moreover, we need to increase the rates that banks
lend to each other; and we need people to entice people to invest more money in low-risk assets.
The Federal Funds Rate has been close to 0% for almost 6 years, making it unserviceable.
Currently, the economy is booming. GDP is high, the Unemployment rate is low, and oil prices
are low. The low oil prices mean that that this is the best time to increase the interest rates.
Moreover, contractionary monetary policy must not be extreme, as deflation is a looming threat.
The effective method that must be used in order to increase interest rates is by doing it gradually.
Thereby, we propose to increase interest rates at by a maximum of 0.5%. And, only if in the next
3 quarters the economy appears to comply with our dual mandate, we should influence the
increase of the FFR once more next year.

9. APPENDIX
Figure 1: Percentage Change in Real Gross Domestic Product

10. Figure 2 A: Percent Change in Real Gross Domestic Product Per Capita
Figure 2 B: Real Gross Domestic Product per Capita (Chained 2009 dollars)

11. Figure 3 A: Real Personal Consumption Expenditures (chained 2009 dollars)
Figure 3 B: Percent Change in Real Personal Consumption Expenditures

12. Figure 4: Percentage Change in Real Gross Private Domestic Investment
Figure 5: Real Government Consumption Expenditures and Gross Investment (Chained
2009 Dollars)

13. Figure 6: Real Net Exports of Goods and Services (Chained 2009 Dollars)
Figure 7: Percent Change in Real Exports and Real Imports of Goods and Services

14. Figure 8: The U3 and U6 Unemployment Rates
Figure 9: Labor Force Participation Rate

15. Figure 10 A: Crude Oil Prices (Dollars per Barrel)
Figure 10 B: Percent Change in Crude Oil Prices

16. Figure 11: Percent Change in the Consumer Price Index (CPI)
Figure 12: Consumer Confidence (Michigan sentiment)

17. Figure 13: Inflationary Expectations
Figure 14: U.S. Dollar Index

18. Figure 15: Percentage Change in the Stock Market Indicators:
Figure 16: Effective Federal Funds Rate

19. Additional Sources used:
http://www.frbsf.org/economic-research/files/el2015-36.pdf
https://www.stlouisfed.org/publications/regional-economist/july-2012/quantitative-easing-
lessons-weve-learned