This lesson utilizes the January 28, 2015, statement of the Federal Reserve's Federal Open Market Committee (FOMC) to explore the Federal Reserve's twin goals of price stability and full employment. This lesson discusses the relationship between interest rates and stock prices, the role of uncertainty in markets, and the ambiguity in the signals from the FOMC statement. 

KEY CONCEPTS

Bond, Central Banking System, Federal Reserve, Interest Rate, Macroeconomic Indicators, Macroeconomics, New York Stock Exchange (NYSE), Stock, Stock Market, Substitute Good

STUDENTS WILL

  • Understand the background and meaning of the January 28, 2015, Federal Open Market Committee decision with respect to the federal funds rate.
  • Explore the relationship between the federal funds rate and stock prices.
  • Analyze the FOMC statement for signs of future action.
  • Discuss the role of uncertainty in market stability.

Current Key Economic Indicators

as of April 4, 2015

Inflation

The Consumer Price Index for All Urban Consumers (CPI-U) increased 0.2% in February on a seasonally adjusted basis. Over the last 12 months, the all-items price index was unchanged. The energy index increased after several months of decline. Core inflation rose 0.2% in February, the same increase as in January.

Employment and Unemployment

The unemployment rate stayed at 5.5% in March, 2015, according to the latest release from the Bureau of Labor Statistics on April 3, 2015. The number of jobs added was much lower than in previous months, with only 126,000 new jobs added to the economy, the fewest number since December of 2013. Some job categories added workers, including health care, professional and business services, financial services, and retail. Average hourly wage growth was 7 cents, but average hours worked fell.

Real GDP

Real GDP increased 2.2% in the fourth quarter of 2014, according to the final estimate released by the Bureau of Economic Analysis. This estimate is consistent with the revised estimate. In the third quarter, real GDP increased 5.0%. Consumer spending rose 4.4%, compared to 3.2% in the third quarter. Business investment and exports also increased. Offsetting these gains were increases in imports and decreases in federal government spending, particularly defense spending. (

Federal Reserve

In its March 18, 2015, statement, the FOMC cited the continued growth of the labor market, increased household and business spending, and below-target inflation as indicators of an economy that continues to recover. They expect below-target inflation to rise as oil prices increase in the medium term. The statement reaffirmed the FOMC intention to keep the federal funds rate at its current low level, but also said that a rate hike was highly unlikely at its April meeting. Notably, the FOMC dropped the word "patient" from its language describing its stance on an improving economy and a rate hike. The Fed revised downward its economic projections, including the rate of unemployment that would sustain a stable inflation rate.

INTRODUCTION

The Federal Open Market Committee (FOMC) of the Federal Reserve System (Fed) meets approximately every six weeks to decide on its use of the two policy tools at its disposal: setting the federal funds rate and engaging in open market operations. (Note: changing the reserve requirement is a rarely used third tool). The federal funds rate is the interest rate at which banks lend funds to other banks, using the Federal Reserve as an intermediary. Open market operations consist of buying and selling financial assets, changing the lending capacity of financial institutions.

The Fed instituted an asset buy-back program in 2008 in an effort to stimulate the economy (QE1). This program has been renewed (QE2 and QE3) until October of 2014. In addition, the FOMC has maintained the federal funds rate target at a range of 0 to 1/4 percent since its December 16, 2008 meeting.  The fed funds rate has been kept at this historically low level because of the low (or sometimes negative) growth rates of real GDP due to the lingering effects of the recession. 

This lesson uses the January 28, 2015, statement of the FOMC to analyze the reaction of the stock market to the statement, to discuss the role of uncertainty in markets, and to explore the relationship between interest rates and stock prices.

RESOURCES


Key Economic Indicators

as of February 6, 2015

Inflation

The Consumer Price Index for All Urban Consumers (CPI-U) declined 0.4% in December on a seasonally adjusted basis. The gasoline index fell 9.4% and was the main cause of the decrease in the seasonally adjusted all items index. The all items index increased 0.8% over the last 12 months, although the core inflation rate (less food and energy) did not change in December.

Employment and Unemployment

The unemployment rate rose to 5.7% in January of 2015, according to the Bureau of Labor Statistics release of Feb. 6, 2015. Total nonfarm employment rose by 257,000. Job gains were particularly strong in retail trade, construction, health care, financial activities, and manufacturing.This is the second month in a row that posted gains in construction and manufacturing.

Real GDP

Real GDP increased 2.6% in the fourth quarter of 2014, according to the advance estimate released by the Bureau of Economic Analysis. Consumer spending drove growth due to the reduction in gas prices, while a decrease in government expenditures was the most significant drag on growth. Third quarter growth was 5%.

Federal Reserve

In its January 28, 2015, statement, the FOMC cited the continued growth of the labor market, increased household and business spending, and below-target inflation as indicators of an economy that continues to recover. They expect below-target inflation to rise as oil prices and other "transitory" effects diminish. The statement reaffirmed the FOMC intention to keep the federal funds rate at its current low level. Notably, the FOMC added international variables to its list of factors to monitor for the timing of a rate increase.

PROCESS

  1. Tell students that when the FOMC statement was released on Jan. 28 (indicating the Fed was going to stay the course with respect to the federal funds rate), stock prices fell almost 200 points, or by 1.1%. Ask students if they think there was a connection between the FOMC statement and the drop in stock prices (answers will vary).

    Tell students to assume that the price of beef increases. What will happen to the demand for chicken? (it will increase because the two goods are substitutes). Tell students that this same relationship exists between stocks and bonds (Note: to review what the difference is between stocks and bonds, go to Difference between Stocks and Bonds .) For example, if the price of bonds were to fall, the demand (and therefore the price) of stocks would decrease.

    Tell students to assume that they can buy a bond for $100 that will pay them $105 in a year. What is the yield, or return, to this bond? (5%). Now tell them to assume that the price of the bond falls to $97. They will still get $105 at the end of the year. Has the interest rate, or yield, of this bond increased or decreased? (increased--you get $8 in interest instead of $5). Tell students that the price of bonds and interest rates has an inverse, or negative relationship.

    Tell students to assume that stocks and bonds are substitute investment instruments. If interest rates increase, what will happen to the price of bonds? (bond prices will fall). If bond prices fall, what will happen to the demand for stocks (the demand for stocks--and their prices--will fall).  In general, the relationship between interest rates and stock prices are as follows:


     
  2. Point out to students that stock prices fell when the FOMC statement was released, but interest rates did NOT increase. In fact, the FOMC stated that they would keep the federal funds rate at near-zero levels.

    Show students the following graph, depicting the federal funds rate and stock prices:


     
  3. Ask students if the negative relationship between interest rates and stock prices appears in this graph (yes, but only until about 1996--and even then not consistently). Ask them what the relationship between the federal funds rate and stock prices have been in recent years (there hasn't been a relationship--the correlation between the two has been close to zero. This is because the federal funds rate has been so consistently low that there has not been any variability to cause a change in stock prices)
     
  4. Point out to students that the federal funds rate and stock prices actually had a positive relationship for much of the time since the late 1990's. Ask students what might have caused that relationship (the economy was growing in the late 1990's and strong overall growth fueled the stock market. At the same time, the Fed was raising the interest rate to try to rein in growth to keep inflation in check).

    Remind students that when the price of beef increased, people would want to buy more chicken. But that is true if we hold everything else constant. What would happen if some disease killed all the pigs (swine flu)? Now the relationship between the price of beef and the demand for chicken is not that clear-cut. It could be the case that the demand for both beef and chicken increase even as the price of both rise.

    Tell students that the negative relationship between interest rates and stock prices is a ceteris paribus relationship--it assumes that nothing else is changing. But, of course, other macro variables are changing: price of oil, overall consumer spending, etc., sometimes causing a positive relationship between interest rates and stock prices.
     
  5. Tell students that in spite of the out-of-the-ordinary relationship between interest rates and stock prices in the past few years, the theoretical basis for a negative relationship remains--when interest rates go up, ceteris paribus, we would expect stock prices to go down. ???It is this negative relationship that causes market watchers to try and see into the future when the FOMC releases its statements. The overriding question is: when is the Fed going to raise the federal funds rate? And as we saw in this latest release, just the anticipation of a rate hike can cause a reaction in the stock market.

    Tell students to go to the latest release: FOMC Statement, January 28, 2015 . Tell them to read the first paragraph. Which statements in the first paragraph might lead the stock market to think that a rate hike is NOT in the immediate future? (the last two sentences). What statements in the first paragraph might lead the stock market to think that a federal funds rate hike might be coming soon? (the first five sentences).

    Have students read the second paragraph. What are the mixed signals in the second paragraph, suggesting both the possibility of an interest rate hike fairly soon vs. the economy has a way to go before a rate hike is necessary? (the labor market is getting close to full employment; inflation is currently low, but the reasons for that are "transitory" and they expect it to rise in the medium term).

    Have students read the third paragraph, with particular attention to the last three sentences. Ask students what their interpretation of the Fed's intentions are (answers will vary). 
     
  6. Ask students if they think the stock market reacted appropriately (answers will vary). Point out that the ambiguity in the Fed's statement led the class to develop different interpretations of what is likely to happen in the future and more importantly, when. Likewise, the stock market has the same struggle with interpretation. Tell students that uncertainty in markets leads to instability and declines. Refer students back to the graph above--when interest rates were low and stable (the Fed had promised to keep them low for an extended period of time), that lent stability to the market, so even though interest rates didn't change, stock prices increased. 

ASSESSMENT ACTIVITY

CONCLUSION

The Federal Reserve Open Market Committee (FOMC) meets approximately every six weeks to review the Federal Reserve's monetary policy positions. In this latest report, the FOMC notes that the labor market continues to improve. In addition, the FOMC believes that inflation is contained for the short term, but the factors keeping it in check are transitory. 

For these reasons, the FOMC decided to keep the federal funds rate at its current low level (0%-0.25%). The FOMC also signaled that they will continue to monitor the inflationary risks, including keeping an eye on international markets. 

The stock market reacted negatively after the FOMC release because it is worried that the Fed will act sooner that it would like in raising interest rates. Because there is a negative relationship between the federal funds rate and the stock market, the market would prefer the Fed withhold raising rates for as long as possible.

EXTENSION ACTIVITY

Tell students to assume that at their next meeting, the FOMC announces that on August 1, 2015, they will raise the federal funds rate to 0.5%. Ask, what will be the immediate effect on the stock market, the day that statement is released? (stock prices will probably fall, ceteris paribus). Ask what will happen to stock prices (again, ceteris paribus) on August 1 when the rate increase goes into effect? (probably nothing--the market has already reacted to the rate increase when it was announced, and by August 1, the uncertainty in the market has been removed)

EDUCATOR REVIEWS