Focus on Economic Data: The Federal Reserve System and Monetary Policy - September 24, 2002
This lesson printed from:
Posted September 25, 2002
Author: Stephen Buckles
Posted: September 25, 2002
“The Federal Open Market Committee decided today to keep its target for the federal funds rate unchanged at 1 3/4 percent. "The information that has become available since the last meeting of the Committee suggests that aggregate demand is growing at a moderate pace.
Current Key Economic Indicatorsas of May 5, 2013
On a seasonally adjusted basis, the Consumer Price Index for All Urban Consumers decreased 0.2 percent in March after increasing 0.7 percent in February. The index for all items less food and energy rose 0.1 percent in March after rising 0.2 percent in February.
Total nonfarm payroll employment rose by 165,000 in April, and the unemployment rate was little changed at 7.5 percent. Employment increased in professional and business services, food services and drinking places, retail trade, and health care.
Real gross domestic product increased at an annual rate of 2.5 percent in the first quarter of 2013 (that is, from the fourth quarter to the first quarter), according to the "advance" estimate released by the Bureau of Economic Analysis. In the fourth quarter, real GDP increased 0.4 percent.
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...
“The Federal Open Market Committee decided today to keep its target for the federal funds rate unchanged at 1 3/4 percent.
"The information that has become available since the last meeting of the Committee suggests that aggregate demand is growing at a moderate pace.
"Over time, the current accommodative stance of monetary policy, coupled with still robust underlying growth in productivity, should be sufficient to foster an improving business climate. However, considerable uncertainty persists about the extent and timing of the expected pickup in production and employment owing in part to the emergence of heightened geopolitical risks.
"Consequently, the Committee believes that, for the foreseeable future, 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.”
This complete press release is available at: www.federalreserve.gov/BoardDocs/Press/monetary/2002/20020924/default.htm
Reasons For A Case Study On The Federal Reserve Open Market Committee
Following recent Federal Open Market Committee announcements, newspapers across the country have had front-page stories about the Federal Reserve actions to target interest rates and boost spending and employment in the U.S. economy. Attention has only increased as the economy entered a recession beginning in March of last year and real GDP actually fell in the first three quarters of 2001. The announcements reflect 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 last year in an effort to strengthen the economy. An understanding of monetary policy in action is fundamental to developing a thorough understanding of macroeconomics and the U.S. economy.
Notes to Teachers
The material in this case study in italics is not included in the student version. This initial case study of the semester introduces relevant concepts and issues. Subsequent case studies following FOMC announcements will describe the announcement and add concepts and complexity throughout the semester.
You may wish to use the following larger versions of the graphs and tables from this lesson for overhead projection or handouts in class:
Guide To Announcement
From January 3 to December 11 of 2001, the Federal Reserve Open Market Committee (FOMC) lowered the target federal funds rate 11 times from 6.50 percent to 1.75 percent (a total reduction of 4.75 percent). This is the lowest target federal funds rate in forty years. At each of the six 2002 meetings, the FOMC decided to leave the federal funds rate unchanged.
The first paragraph of the announcement summarizes the current monetary policy changes - this month it is the decision to leave the target federal funds rate unchanged. The Federal Reserve Board of Governors also sets the discount rate, through a technical process of approving requests of the twelve Federal Reserve Banks. The discount rate also remained unchanged at this meeting and is not mentioned in the announcement.
In the second and third paragraphs, the Federal Reserve discusses the reasoning behind their decision. The fact that “aggregate demand is growing at a moderate pace” refers to modest improvement in economic conditions. The FOMC indicates in the third paragraph that the long-run prospects are good. Current monetary policy is accommodative - meaning it should permit economic expansion. The FOMC members expect continued productivity growth. Both should help the economy return to full strength.
Still, there is concern that production and employment may not grow as rapidly as one might wish or as fast as is possible.
As a result, the Federal Reserve believes the best way to maintain stable prices and sustain economic growth is to leave the target federal funds interest rate unchanged. The risks are reported as weighted towards conditions that may generate economic weakness. That is, the FOMC has a negative bias regarding possible future changes in the target federal funds rate, indicating that the Fed is more likely to consider reducing rates in the near future as opposed to raising them.
During the last half of the 1990s, real GDP grew at rates more rapid than those in the first half of the decade. That growth began to slow at the end of 2000. Real GDP increased at annual rates of 4.1 percent and 3.8 percent in 1999 and 2000. During the first three quarters of 2001, real GDP actually decreased. For the year as a whole, real GDP increased only by .3 percent. The slowing growth over the last two quarters of 2000 and the first three quarters of 2001 was one indication of the need to use a monetary policy that would boost spending in the economy. The FOMC responded by cutting the target federal funds rate throughout the year as noted above. During the fourth quarter of 2001, real GDP increased at an annul rate of 2.7 percent. In the first quarter of 2002, real GDP the annual rate of growth increased even more rapidly at a rate of 5.0 percent - evidence that the stimulative monetary policy is having an effect. In the second quarter of 2002 GDP increased at a rate of 1.1%. (For more on changes in the rate of growth of real GDP and the current recession, see the most recent GDP Case Study.)
The FOMC used policies actively throughout much of the 1990s. The FOMC had 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 once again in 1999, the Federal Reserve raised rates six times from June 1999 through May of 2000.
On November 26, 2001, the National Bureau of Economic Research (NBER) announced though its Business Cycle Dating Committee that it had determined that a peak in business activity occurred in March of 2001. That signals the official beginning to a recession.
The NBER defines a recession as a "significant decline in activity spread across the economy, lasting more than a few months, visible in industrial production, employment, real income, and wholesale-retail trade." The current data show a decline in employment, but not as large as in the previous recession. Unemployment has also increased during the period, only beginning to fall in the last two months. Real income growth slowed but did not decline. Manufacturing and trade sales and industrial production have both declined and now appear to be turning around.
While the common media definition of a recession is two consecutive quarters of decline in real GDP, this recession began before quarterly real GDP actually declined.
The last recession began in July of 1990 and ended in March of 1991, a period of eight months. However, the beginning of the recession was not announced until April of 1991 (after the recession had actually ended). The end of the recession was announced in December of 1992, almost 21 months later. One of the reasons the end of the recession was so difficult to determine was the economy did not grow very rapidly even after it came out a period of falling output and income.
Many observers are now stating that the 2001 recession may have ended in December of 2001. The National Bureau of Economic Research has not yet declared the end of the recession.
For the full press release from the National Bureau of Economic Research see: http://cycles-www.nber.org/cycles/november2001/recessnov.html
Tools of the Federal Reserve
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 along with the discount rate, but the change does not have a very important effect. In this announcement, the discount rate is not changed.
Banks are required to hold a portion (either 10 or 3 percent of most deposits, 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 what are called excess, reserves. The requirement is seldom changed, but it is potentially very powerful.
For more background on the Federal Reserve and resources to use in the classroom, go to www.federalreserve.gov .
How does Monetary Policy Work?
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 has an increased ability to make more loans, which in turn will 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 and appliances, for example) 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 less than the 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.
- What are the Federal Reserve current observations and concerns?
[While the Federal Reserve is optimistic about future conditions, there still is concern that economic conditions are not rapidly improving]
- What tools can the Federal Reserve use?
[The Federal Reserve can buy or sell bonds, which in turn lower or increase the federal funds rate. The Federal Reserve can also change reserve requirements and the discount rate.]
- If the Federal Reserve is concerned about lack of economic expansion, what is it likely to do with its open market operations and the federal funds rate?
[The Federal Reserve would purchase bonds to expand the money supply and reserves and lower the target federal funds rate.]
- If the Federal Reserve is concerned about lack of economic expansion and decided to use changes in reserve requirement and the discount rate, what would it do?
[The Federal Reserve would lower reserve requirements and decrease the discount rate.]
- How do changes in monetary policy affect spending in the economy?
[If banks have fewer reserves, they cannot make as many loans. The reduction in loans and the resulting higher interest rates discourage business (and consumer) borrowing and spending. In the case of too little growth or a reduction in spending, the increased availability of loans and lower interest rates may encourage businesses and consumers to increase their spending.]
- Challenge Question: What are some "geopolitical risks" that could influence future economic conditions? How would economic conditions be affected?
[Geopolitical risks include events such as a future terrorist attack or a war with Iraq. Related risks include actions such as higher oil prices, as well as a reduction in consumer confidence and spending. If consumers become nervous about future economic and political conditions, some may reduce spending leading to a falling real GDP and rising unemployment.]