Focus on Economic Data: The Federal Reserve System and Monetary Policy - October 2001
This lesson printed from:
"The Federal Open Market Committee decided today to lower its target for the federal funds rate by 50 basis points to 2-1/2 percent. In a related action, the Board of Governors approved a 50 basis point reduction in the discount rate to 2 percent.
"The terrorist attacks have significantly heightened uncertainty in an economy that was already weak. Business and household spending as a consequence are being further damped. Nonetheless, the long-term prospects for productivity growth and the economy remain favorable and should become evident once the unusual forces restraining demand abate.
"The Committee continues to believe that, against the background of its long-run goals of price stability and sustainable economic growth and of the information currently available, the risks are weighted mainly toward conditions that may generate economic weakness in the foreseeable future.
"In taking the discount rate action, the Federal Reserve Board approved requests submitted by the Boards of Directors of the Federal Reserve Banks of Boston, New York, Cleveland, Richmond, Atlanta, St. Louis, Kansas City and San Francisco."
(This press release is available at: www.federalreserve.gov/BoardDocs/Press/General/2001/20011002/default.htm)
Reasons for a Case Study on the Federal Reserve Open Market Committee
On October 3, almost every newspaper in the country had a front-page story about the most recent Federal Reserve action to lower interest rates and boost spending and employment in the U.S. economy. The announcement reflects serious concerns with the state and direction of the economy. This case study is intended to guide students and teachers through an analysis of the actions the Federal Reserve began to take on October 2. An understanding of the monetary policy in action is fundamental to developing a thorough understanding of macroeconomics and the U.S. economy.
Guide to Announcement
From January 3 to September 18 of this year, the Federal Reserve Open Market Committee (FOMC) lowered the target federal funds rate from 6.50 percent to 3.00 percent. The announcement on October 2 lowers the rate once more and marks the ninth time that it was lowered in response to concerns of slowing growth in spending and the possibility of a recession. The target federal funds rate is now lower than it has been in almost forty years.
The FOMC guides monetary policy. The first paragraph of the announcement summarizes the current policy changes. The committee is changing that policy by causing the federal funds rate to fall by one-half of a percentage point. (There are 100 basis points in one percent. Fifty basis points equals one-half of one percent). The Federal Reserve Board of Governors sets the discount rate, through a technical process of approving requests of the twelve Federal Reserve Banks. (See the last paragraph of the announcement.) The discount rate was also lowered by one-half of one percent.
The second paragraph suggests that the terrorist attacks of September 11th prompted increased fears and concerns in the already weak economy. This uncertainty may cause consumers to decrease their consumption spending, and businesses to lower their investment spending. Reductions may lower retail sales, lead to cutbacks in production, and create rising unemployment. Therefore, the Federal Reserve lowered interest rates in order to encourage spending and investment and stabilize the economy. In addition, the Federal Reserve is reassuring the public that after the fears, concerns and uncertainty in the economy subside, the economy will strengthen due to the continued productivity growth.
The third paragraph provides an indication of the longer-run strategy of the Open Market Committee. While this statement is no guarantee, it is an indication the committee members believe further lowering of interest rates may be necessary to strengthen spending in the economy.
The final paragraph refers to the technical requests by Federal Reserve Banks to the Board of Governors of the Federal Reserve System to lower the discount rate by one-half of a percentage point.
The Federal Reserve lowered the target federal funds rate in a series of steps beginning in July of 1990 until September of 1992, all in response to a recession beginning in July of 1990 and ending in March of 1991. Then as inflationary pressures began to increase in 1994, the Federal Reserve began to raise rates in February. In response to increased inflationary pressures in 1999, the Federal Reserve raised rates six times from June 1999 through May of 2000.
Between January 3 and October 2, the Federal Reserve lowered the target federal funds rate 9 times by a total of a 4.0 percent, from 6.5 percent to 2.5 percent. This is the lowest target federal funds rate since 1962.
The rate of growth in real GDP has been increasing over the last several years, but began to slow in the middle of last year. Changes in real GDP at annual rates were 2.3, 5.7, 1.3, and 1.9 percent for each quarter of 2000. During the first and second quarters of 2001, GDP grew at an annual rate of 1.3 and 0.3 percent respectively. The slowing growth over the past four quarters, relative to the last several years, has been one indicator of the need to use a monetary policy that will boost spending in the economy and help to avoid a recession - an actual decrease in real GDP. (For more on changes in the rate of growth of real GDP, see the most recent GDP Case Study).
Federal Open Market Committee (FOMC)
The primary function of the FOMC is to direct monetary policy for the U.S. economy. The FOMC meets about every six weeks. (The next meeting is November 6). Seven Governors of the Federal Reserve Board and five of the twelve Presidents of the Federal Reserve Banks make up the committee. Governors are appointed by the U.S. President and confirmed by the U.S. Senate. Presidents of the Federal Reserve Banks are selected by the Boards of each Bank. Monetary policy works by affecting the amount of money that is circulating in the economy. The Federal Reserve can change the amount of money that banks are holding in reserves by buying or selling existing U.S. Treasury bonds. When the Federal Reserve buys a bond, the seller deposits the Federal Reserves' check in her bank account. As a bank's reserves increase, it can make more loans, which increase the amount of money in the economy.
Competition among banks forces interest rates down as banks compete with one another to make more loans. If businesses are able to borrow more to build new stores and factories and buy more computers, total spending increases. Consumer spending that partially depends upon levels of interest rates (automobile, appliances, etc.) is also affected. Output will tend to follow and employment may also increase. Thus unemployment will fall. Prices may also increase.
When the Federal Reserve employs an expansionary monetary policy, it buys bonds in order to expand the money supply and simultaneously lower interest rates. Although gross domestic product and investment increase, this may also stimulate inflation. If growth in spending exceeds growth in capacity, inflationary pressures tend to emerge. If growth in spending is below growth in capacity, then the economy will not be producing as much as it could. As a result, unemployment may rise.
When the Federal Reserve adopts a restrictive monetary policy it sells bonds in order to reduce the money supply and this results in higher interest rates. A restrictive monetary policy will decrease inflationary pressures, but it may also decrease investment and real gross domestic product. See the inflation case study for a more detailed discussion of inflation.
How long does it take for monetary policy to have an effect on the economy?
Federal Reserve Goals
The stated goals of the Federal Reserve Open Market Committee are to maintain price stability and sustainable economic growth. (See the fourth paragraph of the announcement.) That means that the Federal Reserve will try to minimize inflation or at least hold inflation to an amount that will not change most peoples' decisions. For all practical purposes, that rate has been between about 2 to 4 percent in recent years.
The goal of sustainable economic growth translates into holding the growth in spending to a level that equals the growth in our capacity. The latter is determined by technology, the amount of labor and the amount of capital - machines, factories, computers, and inventories.
Tools of the Federal Reserve
Banks are required to hold a portion (either 10 or 3 percent, depending upon the size of the bank) of some of their deposits in reserve. Reserves consist of the amount of currency that a bank holds in its vaults and its deposits at Federal Reserve banks. If banks have more reserves than they are required to have, they can increase their lending. If they have insufficient reserves, they have to curtail their lending or borrow reserves from the Federal Reserve or from another bank that may have extra or excess reserves. The requirement is seldom changed, but it is potentially very powerful.
Open Market Operations:
The Federal Reserve buys and sells bonds and by doing so, increases or decreases banks' reserves and their abilities to make loans. As banks increase or decrease loans, the nation's money supply changes. That, in turn, decreases or increases interest rates. Open market operations are the primary tool of the Federal Reserve. They are often used and are quite powerful. This is what the Federal Reserve actually does when it announces a new target federal funds rate. The federal funds rate is the interest rate banks charge one another in return for a loan of reserves. If the supply of reserves is reduced, that interest rate is likely to increase.
Banks earn profits by accepting deposits and lending some of those deposits to someone else. They sometimes charge fees for establishing and maintaining accounts and always charge borrowers an interest rate. Banks are required by the Federal Reserve System to hold reserves in the form of currency in their vaults or deposits with Federal Reserve System.
When the Federal Reserve sells a bond, an individual or institution buys the bond with a check on their account and gives the check to the Federal Reserve. The Federal Reserve removes an equal amount from the customer's bank's reserves. The bank, in turn, removes the same amount from the customer's account. Thus, the money supply shrinks.
The discount rate is the interest rate the Federal Reserve charges banks if banks borrow reserves from the Federal Reserve itself. Banks seldom borrow reserves from the Federal Reserve and tend to rely more on borrowing reserves from other banks when they are needed. The discount rate is often changed as it is in this announcement, but the change does not have a very important effect.
For more background on the Federal Reserve and resources to use in the classroom, go to www.federalreserveeducation.org/resources/search/?rTopic=Monetary%20Policy.
How often does the federal reserve engage in open market operations?
The Beige Book ? A Survey of Current Economic Conditions
The Federal Reserve's report on economic conditions across the country is released in the "Beige Book" (named for its beige cover) two weeks prior to each meeting of the Federal Reserve Open Market Committee. The following is an excerpt from the Beige Book released on September 19, 2001, in preparation for the meeting on October 2, 2001.
Reports from Federal Reserve Districts generally indicated that overall economic activity remained sluggish in August and early September, with several suggesting that activity slowed further. Upward price pressures were again restrained in nearly all Districts. Input cost pressures were said to be easing as well.
Overall consumer spending remained soft in most of the country during August and early September, while upward pressures on retail prices were subdued. Over half of the District reports indicated that retail sales were flat to down in the reporting period. Atlanta and Minneapolis reported retail sales increases, as did Dallas but from very weak levels. In the important back-to-school segment, merchants in the Boston, Chicago, and St. Louis Districts noted strong sales, while those in the New York, Philadelphia, and Kansas City regions had mixed, less-than-expected, and flat results, respectively. Federal income tax rebates had only a limited effect on spending in August, with New York and Chicago indicating no significant impact, while the Atlanta report suggested that tax rebates (along with heavy discounting) boosted overall sales. Minneapolis noted that state sales tax rebates helped retail sales. Overall lending activity was reported to be mixed, as household demand for loans remained strong in most areas while softness in business lending persisted.
Labor markets continued to ease in most parts of the country in August with over half the District reports suggesting soft and/or softening demand for labor. Boston and St. Louis indicated that demand for high-tech workers continued to erode, while Atlanta suggested that potential employers had become much more selective and high-tech job searches had become longer. There were scattered reports of moderately increasing wages but, for the most part, upward wage pressures continued to ease along with labor demand. In fact, the Cleveland report suggested that unions were trading off negotiated wage increases in exchange for job security provisions. Contacts in four Districts expressed concern over rising health insurance costs, while those in the Atlanta and Chicago regions also noted rising liability insurance costs.
Overall manufacturing activity was weak again in August, but there were positive signs contained in a few District reports. Virtually all regions reported that new orders and production were weak, and nearly one-half suggested that conditions had deteriorated further. Real estate and construction activity were mixed, as the residential side remained strong, while the commercial segment softened further.
The Beige Book report can be found at: www.federalreserve.gov/fomc/BeigeBook/2001/20010919/default.htm
From this summary several important trends can be noted.
- Economic activity across the country is not growing as rapidly as it has been. Most of the Federal Reserve Bank regions are noting slower growth in spending.
- Prices remain stable due to stable input prices including energy prices and wages.
- Growth in demand for labor is slowing and upward pressure on wages is abating. Unemployment has increased to 4.9 percent from its low of 3.9 percent last fall. (See the unemployment case study.) The decreased intensity of competition for employees has reduced some of the wage pressures. However, employees are demanding better benefit packages and health costs are rising, both of which increase the costs of labor.
- Consumer spending is not growing as rapidly as it was, even with the federal income tax rebates of this summer and early fall. Part of this decrease in growth may be due to falling confidence in future economic conditions and to falling stock prices.
The Federal Reserve and Growth in Real GDP
On September 18, 2001 the FOMC released the following unscheduled statement:
The Federal Open Market Committee decided today to lower its target for the federal funds rate by 50 basis points to 3 percent. In a related action, the Board of Governors approved a 50 basis point reduction in the discount rate to 2-1/2 percent. The Federal Reserve will continue to supply unusually large volumes of liquidity to the financial markets, as needed, until more normal market functioning is restored. As a consequence, the FOMC recognizes that the actual federal funds rate may be below its target on occasion in these unusual circumstances.
Even before the tragic events of last week, employment, production, and business spending remained weak, and last week's events have the potential to damp spending further. Nonetheless, the long-term prospects for productivity growth and the economy remain favorable and should become evident once the unusual forces restraining demand abate. For the foreseeable future, the Committee continues to believe that against the background of its long-run goals of price stability and sustainable economic growth and of the information currently available, the risks are weighted mainly toward conditions that may generate economic weakness.
In taking the discount rate action, the Federal Reserve Board approved requests submitted by the Boards of Directors of the Federal Reserve Banks of Richmond, Chicago, Minneapolis, Dallas, and San Francisco.
- Explain why the Federal Reserve lowered target federal funds rate in September and October 2001.
- Explain why the Federal Reserve raised the target federal funds rate in 1999 and 2000.
- How does a change in the target federal funds rate affect spending?
- What are the risks in the Federal Reserve lowering interest rates?
- A role of the Federal Reserve is to maintain the money supply. What is money?
- How do changes in the target federal funds rate affect GDP?
A productive activity is to form a Federal Open Market Committee in your class. Current data and forecasts can be examined. Votes can be taken as to the proper policy. Some roles can be assigned. Bankers, farmers, laborers, stockholders all have opinions and interests in the outcomes of the meetings.
The "Beige Book" consists of the reports of the economic conditions in the 12 Federal Reserve Banks across the country. Those data are part of the information considered by the FOMC when it makes its decisions. Refer to the beige book (www.federalreserve.gov/fomc/BeigeBook/2001/20010919/default.htm) in order to discern the opinions of different workers, industries and retailers. In the current economic slowdown, the following questions might be asked:
Which cities are faring the worst; which are the best?
Which sectors of the economy are faring the worst; which are the best?
The Federal Reserve also has a web-site for economic students located at www.FederalReserveEducation.org. Additional information on monetary policy may be found there.