Focus on Economic Data: The Federal Reserve and Monetary Policy, March 20, 2013

EDUCATOR'S VERSION

This lesson printed from:
http://www.econedlink.org/e1152

Posted April 11, 2013

Standards: 10, 16, 18, 20

Grades: 9-12

Author: Douglas Haskell

Posted: April 11, 2013

DESCRIPTION

This lesson focuses on the March 20, 2013, press release by the Federal Reserve System's Federal Open Market Committee (FOMC) on the current Federal Reserve monetary policy goals and actions. Specifically, the lesson reports the target rate for the federal funds rate, set by the Federal Open Market Committee (FOMC). This lesson is intended to guide students and teachers through an analysis of the actions the Federal Reserve is taking and can take in influencing prices, employment, and economic growth. Through this lesson, students will better understand the dynamics of the U.S. economy, current economic conditions, and monetary policies.

KEY CONCEPTS

Business Cycles, Central Banking System, Economic Growth, Federal Reserve, Macroeconomic Indicators, Monetary Policy, Tools of the Federal Reserve

STUDENTS WILL

  • Explain the meaning of the March 20, 2013, Federal Open Market Committee decision concerning the target for the federal funds rate.
  • Identify the current monetary policy goals of the Federal Reserve and the factors that have recently influenced monetary policy goals.
  • Explain the structure and functions of the Federal Reserve System, Federal Reserve Banks, and the Federal Open Market Committee.
  • Identify the monetary policy options and other tools available to the Federal Reserve to stimulate or contract the economy.

Current Key Economic Indicators

as of November 10, 2014

Inflation

The Consumer Price Index for All Urban Consumers increased 0.1 percent in October on a seasonally adjusted basis. The core inflation rate increased the same amount. For the previous 12 months, the index increased 1.7%, the same rate as reported in the September report.

Employment and Unemployment

According to the October report of the Bureau of Labor Statistics, the unemployment rate fell from 5.9% to 5.8%, and the number of individuals unemployed also decreased. Total nonfarm employment rose by 214,000 in October. Employment gains were concentrated in retail trade, food services and health care.

Real GDP

The advance estimate for real GDP growth in the third quarter of 2014 was 3.5%, a decrease from the revised second quarter growth of 4.6%. Inventory investment reduced third quarter growth, while it added to second quarter growth. In addition, consumer spending increased at a lower rate in the third quarter, compared to the second. Finally, business investment increased in the third quarter, but at a lower rate than in the second quarter.

Federal Reserve

The FOMC believes that the labor market has shown considerable improvement and the risks of inflation rising above its 2% target are low. Therefore, the Federal Reserve announced plans to end its purchase of financial assets. In addition, the federal funds rate will remain at its current low level. However, the FOMC has signaled its willingness to increase the federal funds rate if inflation shows signs of rising above the 2% target.


INTRODUCTION

The Federal Open Market Committee (FOMC) of the Federal Reserve System (Fed) meets approximately every six weeks to determine the nation's monetary policy goals and, specifically, to set the target for the federal funds rate (fed funds rate). The fed funds rate is the interest rate at which banks lend their balances at the Federal Reserve to other banks, usually overnight.

The FOMC has maintained the current target federal funds rate at a range of zero to 1/4 percent since its December 16, 2008 meeting.  The fed funds rate has been kept at this historically low level due to a long period of low and often negative real GDP growth, record numbers of non-farm employment losses, and a persistently high unemployment rate.

This lesson focuses on the March 20, 2013, press release by the Federal Open Market Committee on the current Federal Reserve monetary policy actions and goals.

[Note: In the second semester of the 2012-2013 school year (January-May), there will be three Focus on Economic Data lessons regarding the Federal Reserve and Monetary Policy.

This lesson focuses on the FOMC's March 20, 2013, meeting.  The lesson about the FOMC meeting scheduled for April, 2012, will address more specific issues of Fed policy tools, policy options, and new Fed programs to counter recessionary pressures and the current financial market problems.]

[Note:  On occasion, the FOMC holds unscheduled face-to-face or conference call meetings to make more timely policy decisions in response to unusual economic events or conditions.  The policy decisions made as a result of any of these unscheduled meetings will be included in the lesson on the next scheduled meeting.]

RESOURCES


Key Economic Indicators

as of March 20, 2013

Inflation

On a seasonally adjusted basis, the Consumer Price Index for All Urban Consumers was unchanged in January, as it was in December. The index for all items less food and energy rose 0.3 percent in January after rising 0.1 percent in December.

Employment and Unemployment

Total nonfarm payroll employment increased by 236,000 in February, and the unemployment rate edged down to 7.7 percent. Employment increased in professional and business services, construction, and health care.

Real GDP

Real gross domestic product increased at an annual rate of 0.1 percent in the fourth quarter of 2012 (that is, from the third quarter to the fourth quarter), according to the "second" estimate released by the Bureau of Economic Analysis. In the third quarter, real GDP increased 3.1 percent.

Federal Reserve

To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens. In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent.

PROCESS

The old saying goes... "No news is good news." 

Perhaps that is about all there is to say about the latest monetary policy statement from the Federal Open Market Committee.  The FOMC's March 20, 2013, statement echoed other recent statements, quickly setting aside the impact of "weather-related disruptions" in late 2013.

The statement began with an overall look at the health of the U.S. economy, citing economic growth as "moderate" and improving labor markets.  It described consumer and business spending as having "advanced" and a "strengthened" housing market. The only negative in the opening was a reference to potential restrictions resulting from fiscal policy (tax and spending) issues.

As for specific monetary policies - nothing really new, this time

The Federal Open Market Committee (FOMC) of the Federal Reserve System (Fed) has maintained its target for the federal funds rate at a range of zero to 1/4 percent since December 16, 2008.  This historically low target was intended at the time to provide the liquidity and low interest rates to stimulate the economy at the beginning of the recession and during the banking crisis.  The federal funds rate is the interest rate at which member bank loan reserves to other member banks overnight so that banks can meet their reserve requirements.

Since that time, the FOMC has kept the federal funds rate very low and has provided additional stabilization and stimulus through a variety of programs intended to improve the balance sheets of banks and liquidity in credit markets.  The Fed has purchased hundreds of billions of dollars of securities through "quantitative easing" programs referred to as "QE." Later, a second round of purchases was enacted, commonly referred to as "QE2."  The so-called "operation twist" began in September, 2011.  By selling shorter-term bonds and purchasing longer-term bonds, the Fed hoped to drive down the interest rate on 10-year bonds.

At its most recent meeting, the FOMC reiterated its commitment to low interest rates and stimulatory economic policies.

Note: Unless otherwise cited, all quoted material in this lesson is from the March 20, 2013, FOMC "Monetary Policy" statement.  www.federalreserve.gov/newsevents/press/monetary/20130320a.htm

Board of Governors of the Federal Reserve System
Federal Open Market Committee
Monetary Policy
March 13, 2012

"Information received since the Federal Open Market Committee met in January suggests a return to moderate economic growth following a pause late last year. Labor market conditions have shown signs of improvement in recent months but the unemployment rate remains elevated. Household spending and business fixed investment advanced, and the housing sector has strengthened further, but fiscal policy has become somewhat more restrictive. Inflation has been running somewhat below the Committee's longer-run objective, apart from temporary variations that largely reflect fluctuations in energy prices. Longer-term inflation expectations have remained stable."

The statement began with FOMC's broad view of the U.S. economy, referring to the events and changes since the last FOMC meeting.  In this case, similar to the last announcement, referring to a return to "moderate growth."

The next section of the statement reaffirmed the FOMC's commitment to its Congressional mandate, to maintain a stable price level, economic growth, and full employment.  This mandate was first established by a federal law, the "Employment Act of 1946" and then amended by the "Full Employment and Balanced Growth Act" in 1978. The amending act established the goal of "full employment and economic means to do so."

[Note to Teachers: For more information on the Employment Act of 1946, go to: http://research.stlouisfed.org/publications/review/86/11/Employment_Nov1986.pdf ]

[Note to Teachers:  Ask your students if "moderate" growth is enough during these times?  About 12 million people in the U.S. remain unemployed.  Should the Fed and other federal and state agencies take more drastic actions to stimulate economic growth? U.S. real GDP growth in the year 2012 was 2.2 percent.]

"Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee expects that, with appropriate policy accommodation, economic growth will proceed at a moderate pace and the unemployment rate will gradually decline toward levels the Committee judges consistent with its dual mandate. The Committee continues to see downside risks to the economic outlook. The Committee also anticipates that inflation over the medium term likely will run at or below its 2 percent objective."

As always, the FOMC made it clear that it was ready to counter any inflationary pressures.  In this case, the FOMC recognized the recent high energy and food prices, but did not expect long-term and serious impact in the shorter term.

[Note to Teachers: Ask your students: If the FOMC members sense that inflation is a serious threat, what should they do?  Remind the students that a rise in interest rates may slow GDP and employment growth.]

Along with the release of the March 20, 2013, FOMC press release, Federal Reserve Chairman Ben S. Bernanke, held a press conference to comment on the announcement and answer questions.  The news conferences are part of the Fed's committment to increased transparency of its processes and decisions.  To watch the press conference,  click on Figure 2, below, or go to: www.federalreserve.gov/monetarypolicy/fomcpresconf20130320.htm

What will the Fed do?

"To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee decided to continue purchasing additional agency mortgage-backed securities at a pace of $40 billion per month and longer-term Treasury securities at a pace of $45 billion per month. The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. Taken together, these actions should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative."

There was no new policy action on the federal funds rate target - maintaining the low rates of the past two years.  Again, the recent increases in energy and food prices did not impact Fed policy.

"To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens. In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored."

[Note to Teachers: Ask your students what the Fed should do.  Or, what else can they do, since the federal funds rate is so low?  Can the Fed directly help to create jobs?  Should the Fed have the power to force banks to make more loans that create jobs?]

The Federal Funds Rate

Targeting the federal funds rate has been the primary policy of the FOMC in recent years.  Remember, the federal funds target rate is the interest rate at which depository institutions (banks, etc.) lend balances (excess reserves) at the Federal Reserve to other depository institutions overnight. The purpose of these overnight loans is to allow depository institutions to meet their reserve requirements. 

Banks use their reserves to generate loans.  Loans facilitate investment and consumption.  The lower the cost of the loans, the more investment and consumption - in theory.  In this recovery, low interest rates have not been enough to generate jobs and growth, so the Fed has turned to more direct actions.

If a bank makes a loan, its reserves decrease. If the bank’s reserve ratio drops below the minimum required by the Fed, it must add to its reserves. The bank can borrow reserves from another bank that has a surplus of reserves in its account with the Fed. The interest rate the borrowing bank pays to the lending bank is negotiated between the two banks. The weighted average of all of these negotiated rates is the federal funds effective rate. The FOMC sets a target rate or target range, and uses open market operations to influence bank reserves and the determination of the effective rate. 

In this recovery, low interest rates have not been enough to generate sufficient jobs and growth, so the Fed has turned to more direct actions.  In recent months, job growth has improved and output may be increaseing after a slight downturn in growht in late 2012.  Is "stay the course" the best policy?

Figure 1 below shows the recent history of the target federal funds rate. Note the exceptionally low rate (range of 0-1/4 percent) that has been in effect since December 2008. The up and down fluctuations over time generally mirror the business cycles, as monetary policy is used to promote growth or slow price level increases.

Figure 1

[For more information about business cycles, see the EconEdLink lesson, "Focus on Economic Data: Employment and the Unemployment Rate, February, 2013."   www.econedlink.org.

Open Market Operations

Open market operations are the Federal Reserve's primary tool for implementing monetary policy. The Fed web page briefly explains the objective of open market operations. "Open market operations--purchases and sales of U.S. Treasury and federal agency securities--are the Federal Reserve's principal tool for implementing monetary policy. The short-term objective for open market operations is specified by the Federal Open Market Committee (FOMC). This objective can be a desired quantity of reserves or a desired price (the federal funds rate). The federal funds rate is the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight."

The Federal Reserve's objective for open market operations has varied over the years. "During the 1980s, the focus gradually shifted toward attaining a specified level of the federal funds rate, a process that was largely complete by the end of the decade. Beginning in 1994, the FOMC began announcing changes in its policy stance, and in 1995 it began to explicitly state its target level for the federal funds rate. Since February 2000, the statement issued by the FOMC shortly after each of its meetings usually has included the Committee's assessment of the risks to the attainment of its long-run goals of price stability and sustainable economic growth.”  Source: Open Market Operations

With the target range for the federal funds rate currently at such a low level (0 to 1/4 percent) and the real rate exceptionally low, there is not much potential for use of the typical monetary policy tools to stimulate growth. The Fed has made unprecedented efforts to stabilize credit markets, improve liquidity and encourage lending.

The target federal funds rate set by FOMC is maintained through open market operations. The FOMC will increase or decrease the target rate depending on economic conditions and the Fed’s overall monetary policy goals. The Fed doesn’t actually set the rate, but can influence the rate through open market operations. When a bank buys securities, from the Fed, it then has fewer funds to loan. When a bank sells securities to the Fed, it then has more funds (reserves) to loan.

An alternative for banks that must increase their reserves is to borrow directly from the Federal Reserve through the “discount window.” The discount rate is typically slightly higher than the federal funds rate. The FOMC will typically change the discount rate as it establishes a target for the federal funds rate.

[Note to Teachers:  Ask your students: How important is it that the Federal Reserve has independent power to implement monetary policies to maintain a stable price level, promote employment growth, and stimulate growth in the economy?]  

Was there more FOMC optimism in March 2013?

In recent times, each FOMC statement has begun with the same line, “Information received since the Federal Open Market Committee met in (referencing the date of the previous meeting)."  This opening provides the basic rationale for the meeting decision.  The March 20, 2013, statement began, “Information received since the Federal Open Market Committee met in January suggests a return to moderate economic growth following a pause late last year.”  This was, perhaps, one of the more optimistic sounding introduction in recent times.

Here’s a recent history of this key FOMC language through the last two years of the economic recovery:

  • January 26, 2011: “the economic recovery is continuing, though at a rate that has been insufficient to bring about a significant improvement in labor market conditions.”
  • March 15, 2011: “the economic recovery is on a firmer footing, and overall conditions in the labor market appear to be improving gradually.”
  • April 27, 2011: "economic recovery is proceeding at a moderate pace and overall conditions in the labor market are improving gradually."
  • June 22, 2011: "at a moderate pace, though somewhat more slowly than the Committee had expected.."
  • August 9, 2011: "economic growth so far this year has been considerably slower than the Committee had expected."
  • September 21, 2011: "economic growth remains slow."
  • November 2, 2011: "economic growth strengthened somewhat in the third quarter, reflecting in part a reversal of the temporary factors that had weighed on growth earlier in the year."
  • December 13, 2011: "the economy has been expanding moderately."
  • January 25, 2012:  "economy has been expanding moderately, notwithstanding some slowing in global growth."
  • The March 13, 2012 through June 20, 2012 announcents all referred to growth "expanding moderately."
  • August 1, 2012: "economic activity decelerated somewhat over the first half of this year."
  • September 13, 2013 through December 12, 2012: agan, "expanding moderstely."
  • January 25, 2013: "growth in economic activity paused in recent months, in large part because of weather-related disruptions and other transitory factors."
  • March 20, 2013: a return to moderate economic growth following a pause late last year.

Notice how the language changed slightly from meeting to meeting - mostly a vague assessment.  The language from most of the last few meetings has focused on "moderate" growth.

[Note to teachers: Ask your students what the FOMC might have meant by terms like "on a firmer footing" or "moderate growth,"?  Can they identify some of the economic data the FOMC might have used to make this statement.  Most likely, the  FOMC was referring to the improvement in employment, little inflationary pressure and recently steady GDP growth]   

The Fed and Banking Regulation – the “Stress Tests”

One of the Federal Reserve’s statutory responsibilities is to regulate banks in ways that help to ensure the stability of individual banks and the entire banking system.  On March 14, 2013, the Federal Reserve announced the results of the latest "stress tests" of major banks, the "Comprehensive Capital Analysis and Review (CCAR) program. The stress test process was designed during the 2008-2009 financial crisis to determine if the major banks will be able to meet "capital adequacy requirements" despite large projected losses in an extremely adverse hypothetical economic scenario.

"The Federal Reserve on Thursday announced it has approved the capital plans of 14 financial institutions in the Comprehensive Capital Analysis and Review (CCAR). Two other institutions received conditional approval, while the Federal Reserve objected to the plans of two firms."

"Strong capital levels help ensure that banking organizations have the ability to lend to households and businesses and to continue to meet their financial obligations, even in times of economic difficulty. The Federal Reserve in CCAR evaluates the capital planning processes and capital adequacy of the largest bank holding companies, including the firms' proposed capital actions such as dividend payments and share buybacks and issuances."

Source: Federal Reserve press release, March 14, 2013: www.federalreserve.gov/newsevents/press/bcreg/20130314a.htm

[Note to Teachers: Discuss with students:  Why is it important for people have faith in the stability of individual banks and the banking system?  People are more likely to use banks - save and borrow - if they perceive the system as stable and able to pay its obligations.   Most of the historical "banking crises" have happened when individuals felt they might not be able to access the funds they had on deposit in banks.]

ASSESSMENT ACTIVITY

CONCLUSION

Once again, the FOMC announcement on March 20, 2013, cited improvements in labor markets, household spending, investment and housing, and stable prices as positive signs for the economy.

"Information received since the Federal Open Market Committee met in January suggests a return to moderate economic growth following a pause late last year. Labor market conditions have shown signs of improvement in recent months but the unemployment rate remains elevated. Household spending and business fixed investment advanced, and the housing sector has strengthened further, but fiscal policy has become somewhat more restrictive. Inflation has been running somewhat below the Committee's longer-run objective, apart from temporary variations that largely reflect fluctuations in energy prices. Longer-term inflation expectations have remained stable."

The March 20, 2013, FOMC monetary policy statement confirmed what many economists, analysts and news commentators expected - no change in the federal funds rate target and continuation of programs to improve bank balance sheets and liquidity.

The bottom line: continue the existing policies and keep an eye out for change.

As for inflation, energy prices are the wide card, as oil prices have fluctuated almost month to month.  If energy demand and supply disruptions continue, the FOMC may anticipate more broad inflationary pressures. If other prices do not follow energy, the FOMC may not see the need to raise rates. Watch energy prices and the overall rate of inflation (CPI-U) in the coming months.

12 million Americans remain unemployed after the recession. Real GDP growth has been erratic from quarter to quarter.  More stability of both measures will be an even better sign for the Fed.  Keep an eye in the rate of job growth and output between now and the FOMC's next meeting in  May.

Is this FOMC statement good news or not?

EXTENSION ACTIVITY

The Federal Reserve has published an Internet-based educational resource for teachers and students called "Federal Reserve Education ".

Federal Reserve Education includes sections on the history of the Fed, the structure of the Fed, monetary policy, bank supervision, and financial services.

  1. The above link will take you to the section on "Monetary Policy." Review the "Basics of Monetary Policy." 
  2. Click on "How does the Fed create money?" to learn how Fed actions can influence the money supply.
  3. Click on "Economic Indicators" to review the meaning of gross domestic product, consumer price index, unemployment rate and other economic indicators. 

This will help you better understand the monetary policy goals and actions of the Fed in the context of economic conditions, such as those discussed at the FOMC meetings.

Federal Reserve Education includes a link to a web page that lists a variety of economic data sources (www.forexhound.com/article/Central_Banks/Fed_Background/Economic_Indicators_By_the_Numbers/69850 , www.federalreserveeducation.org/resources/economic_indicators/ ) and additional links to the current data for each indicator.

To find information about your Federal Reserve System district reserve bank, go to: www.federalreserveeducation.org/about-the-fed/ and click on your region on the map.

[Note to Teachers: Have your students look at the information about their region's Federal Reserve Bank.]

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