ECO 372 Week 5 Monetary Policy and the Federal Reserve Example

Why the Fed Cut in Late 2024 and Then Waited: The Federal Reserve's Tools, Its Dual Mandate, the Path From the Policy Rate to Car Loans and the Tariff Dilemma of 2025

[Student Name]

University of Phoenix

ECO/372: Principles of Macroeconomics

Week 5 Assignment

[Instructor Name]

[Date]

Lakeview Precision Components is a composite written for a model paper; policy decisions, rates and research findings come from the sources listed and are stated generally.

The composite Grand Rapids parts supplier sells into a market that runs on credit: most new cars are bought with loans. When auto loan rates rose sharply in 2022 and 2023, its customers' sales slowed. In late 2024, the Federal Reserve began cutting its policy rate, and the company hoped for cheaper car loans and stronger orders. Then the Federal Reserve paused through the first half of 2025. Its finance chief asked why. Monetary policy works through borrowing costs, but the reasons behind a central bank's decisions lie in what it fears most at the moment. This paper explains those decisions.

The Federal Reserve and Its Mandate

The Federal Reserve is the U.S. central bank, with a Board of Governors in Washington and twelve regional banks. Its Federal Open Market Committee sets monetary policy. Congress gave it a dual mandate of maximum employment and stable prices, which it interprets as inflation of 2 percent over time. The Federal Reserve is designed to be independent of short-term political pressure so that it can make unpopular decisions, such as raising rates to fight inflation (Mankiw, 2021).

The Tools

Policy centers on a target band for the federal funds rate, the overnight interbank borrowing rate. The Federal Reserve steers that rate by setting the interest it pays on banks' reserve balances and on overnight reverse repurchase agreements with other institutions. It also influences longer-term rates through its holdings of Treasury and mortgage securities, which it reduced from 2022 onward, and through guidance about its future path.

The Decisions of 2024 and 2025

Having lifted its target range to between 5.25 and 5.50 percent in mid-2023, the Federal Reserve kept it unchanged through mid-2024 as inflation fell. In September 2024 it cut by half a percentage point, then by a quarter point in November and again in December, to 4.25 to 4.50 percent, citing progress on inflation and a cooling labor market. It then held the range steady through the first half of 2025, as officials said inflation remained somewhat above 2 percent and the effects of new tariffs on prices were uncertain (Board of Governors of the Federal Reserve System, 2025).

From the Policy Rate to Car Loans

A change in the federal funds rate passes into other rates through markets. Banks' cost of short-term funding changes, and expectations about future policy move longer-term rates. Auto loan rates depend on banks' funding costs and on rates for two- to six-year terms, so they responded only partly to the late 2024 cuts, especially as longer-term Treasury yields rose late in 2024. Bernanke and Gertler (1995) described a credit channel through which policy also affects the supply of credit and borrowers' balance sheets, amplifying its effects beyond what interest rates alone would suggest.

Lags

Monetary policy affects spending with long and variable lags, often a year or more for its full effect on inflation. The Federal Reserve therefore acts on forecasts, not only on current data, and must judge how much of past tightening is still working through the economy.

A Rule as a Benchmark

Taylor (1993) proposed a rule linking the policy rate to inflation and the output gap: a neutral real rate plus current inflation, then add half of any inflation overshoot above target and half of any output gap. With inflation near 2.6 percent, a 2 percent target, output near potential and a neutral real rate of about 1 percent, the rule suggests a policy rate near 3.9 percent, slightly below the 4.25 to 4.50 percent range of early 2025. The rule supported modest further easing but not urgency, consistent with the decision to wait.

The Tariff Dilemma

The 2025 tariffs raised the prices of imported goods and of domestic goods that compete with them. A one-time increase in the price level need not cause ongoing inflation, so a central bank might look through it. But if businesses and households come to expect higher inflation, the one-time increase can become persistent. Officials faced a choice: cut rates to support growth that tariffs might slow, or hold rates to guard against higher expected inflation. They chose to wait for more evidence, accepting slower relief for borrowers to protect credibility.

Why Credibility Matters

A central bank whose commitment to low inflation is believed can let a one-time price increase pass without triggering a wage-price spiral. Friedman (1968) argued that monetary policy cannot permanently lower unemployment below its natural rate, and that attempts to do so raise inflation expectations. Maintaining credibility earned through the 2022 and 2023 tightening was a central reason for patience in 2025.

The Balance Sheet

Alongside rate decisions, the Federal Reserve continued to shrink its holdings of Treasury and mortgage securities through 2024 and 2025, though it slowed the pace of runoff in 2024 and again in 2025. Reducing the balance sheet tends to push longer-term rates up slightly by leaving more bonds for private investors to hold, working in the same direction as higher policy rates. For car loans and mortgages, which depend on longer-term rates, this quieter tool mattered alongside the headline rate decisions.

Independence Under Pressure

In 2025, the Federal Reserve's decisions drew public criticism from political leaders who wanted faster cuts. Research and experience suggest that central bank independence helps keep inflation expectations anchored, which ultimately allows lower interest rates over time.

What Lakeview Should Watch

Lakeview's finance chief decided to track the Federal Reserve's statements and projections, two- to five-year Treasury yields, which drive auto loan rates, and monthly inflation and employment data. The company kept its forecast cautious, assuming only gradual declines in car loan rates.

Conclusion

The Federal Reserve cut its policy rate in late 2024 as inflation eased and the labor market cooled, then paused in 2025 because inflation remained above target and tariffs threatened to push prices higher. Policy reaches car buyers through market rates and credit conditions with long lags, and a central bank's credibility determines whether a one-time price increase fades or persists.

References

Bernanke, B. S., & Gertler, M. (1995). Inside the black box: The credit channel of monetary policy transmission. Journal of Economic Perspectives, 9(4), 27-48. https://doi.org/10.1257/jep.9.4.27

Board of Governors of the Federal Reserve System. (2025). Monetary policy report. https://www.federalreserve.gov/monetarypolicy/publications/mpr_default.htm

Friedman, M. (1968). The role of monetary policy. The American Economic Review, 58(1), 1-17.

Mankiw, N. G. (2021). Principles of macroeconomics (9th ed.). Cengage.

Taylor, J. B. (1993). Discretion versus policy rules in practice. Carnegie-Rochester Conference Series on Public Policy, 39, 195-214. https://doi.org/10.1016/0167-2231(93)90009-L