Focus on Economic Data: The Federal Reserve System and Monetary Policy - February 2, 2005
This lesson printed from:
Posted February 2, 2005
Author: Stephen Buckles
Posted: February 2, 2005
Updated: March 28, 2006
The Federal Reserve continued a pattern of gradually increasing its target for short-term interest rates. It was the sixth consecutive increase of .25 percent. The Federal Reserve is steadily reducing the monetary stimulus which it used to encourage expansion in the U.S. economy following the 2001 recession.
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...
Have students do this multiple choice activity.
“The Federal Open Market Committee decided today to raise its target for the federal funds rate by 25 basis points to 2-1/2 percent.
“The Committee believes that, even after this action, the stance of monetary policy remains accommodative and, coupled with robust underlying growth in productivity, is providing ongoing support to economic activity. Output appears to be growing at a moderate pace despite the rise in energy prices, and labor market conditions continue to improve gradually. Inflation and longer-term inflation expectations remain well contained.
“The Committee perceives the upside and downside risks to the attainment of both sustainable growth and price stability for the next few quarters to be roughly equal. With underlying inflation expected to be relatively low, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured. Nonetheless, the Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability.
“Voting for the FOMC monetary policy action were: Alan Greenspan, Chairman; Timothy F. Geithner, Vice Chairman; Ben S. Bernanke; Susan S. Bies; Roger W. Ferguson, Jr.; Edward M. Gramlich; Jack Guynn; Donald L. Kohn; Michael H. Moskow; Mark W. Olson; Anthony M. Santomero; and Gary H. Stern.“In a related action, the Board of Governors unanimously approved a 25-basis-point increase in the discount rate to 3-1/2 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San Francisco.”
Reasons for a Case Study on the Federal Open Market Committee (FOMC)
This case study is intended to guide students and teachers through an analysis of the actions the Federal Open Market Committee (or FOMC) is taking to ensure stable prices and sustainable growth in output and income. 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
The first paragraph of the meeting announcement summarizes the current monetary policy changes - this month it is the decision to raise the target federal funds rate by one-quarter of one percent. (There are 100 basis points in one percentage point. Thus, 25 basis points is one-quarter of one percent.)
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 is discussed in the final paragraph of the announcement. It was also increased by one-quarter of a percent. This change parallels the change in the target federal funds rate.
The second paragraph of the release is a discussion of the reasoning behind the decisions. There is only a one-word change from the previous month's announcement. The first sentence means that the committee believes that current monetary policy remains stimulative. Output is increasing at a rate fast enough to gradually increase employment, yet not so fast that inflationary pressures are created.
An indication of likely future policy is in the third paragraph. The Federal Reserve indicates that the risks of inflation are not great and that the rate of growth of real GDP will likely continue. Because of this view, committee members believe that there is no longer a need for stimulative monetary policy. Therefore, they will continue to raise target federal funds rates until there is no longer monetary stimulus. (That likely implication is that the target federal funds rate will continue to be raised by .25 percent at each meeting until it somewhere between 3 and 4 percent.)
The last sentence of the paragraph simply refers to the very real possibility of changes in economic conditions in the meantime and that the committee will respond to those changes in manners it believes are appropriate.
The fourth paragraph describes the votes of the FOMC members on changing the target federal funds rate. All members of the FOMC voted to leave the target federal funds rate unchanged. (Some members have been added and some removed since the previous announcement as the voting rotates among the Federal Reserve Bank Presidents.)
The final paragraph describes the related change in the discount rate.
The Federal Reserve lowered the target federal funds rate from January of 2001 to June of 2003 in response to slowing growth and the recession of 2001. In June of 2004, the FOMC began to reduce the amount of stimulus from monetary policy as members believed that the economy had sufficient stimulus to return to steady growth and that too much continued stimulus would lead to inflationary pressures. Therefore the committee has increased the target federal funds rate at every meeting since by .25 of a percent. It is likely to continue doing so at a similar rate until the committee no longer views the policy as a stimulative one. Most observers would say that the rate will end up being between 3 and 4 percent, perhaps closer to 4 percent.
Figure 1 shows the path of the target federal funds rate since 1990. The gray areas indicate the recessionary periods in 1990-1991 and in 2001.
Recent History of FOMC Actions
The FOMC used monetary policies actively throughout much of the 1990s. The FOMC 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.
During the last half of the 1990s, real GDP grew at more rapid rates than in the first half of the decade. That growth began to slow in 2000. Real GDP increased at annual rates of 4.5 percent and 3.7 percent in 1999 and 2000. For 2001 as a whole, real GDP increased only by .8 percent. The slowing growth and actual decline in real GDP over the third quarter of 2000 and the eventual declines in the first and third quarters of 2001 were indications of the need to use a monetary policy that would boost spending in the economy. The FOMC responded, beginning in January of 2001, by cutting the target federal funds rate throughout the rest of the 2001.
From January 3 to December 11 of 2001, the Federal Reserve Open Market Committee (FOMC) lowered the target federal funds rate eleven times from 6.50 percent to 1.75 percent, at that time, the lowest target federal funds rate in forty years. During the fourth quarter of 2001, real GDP rebounded, but only at an annual rate of 1.6 percent. Real GDP increased only at a rate of 1.9 percent in 2002. At all of the 2002 meetings prior to the November meeting, the FOMC decided to leave the federal funds rate unchanged. In November, the target federal funds rate was once again lowered to 1.25 percent. Then in June of 2003, following a first quarter increase in real GDP of only 1.9 percent, the target federal funds rate was lowered once again, this time to 1 percent. (For more on changes in the rate of growth of real GDP and the recession, see the most recent GDP Case Study.)
Federal Open Market Committee (FOMC)
The primary function of the Federal Open Market Committee is to direct monetary policy for the U.S. economy. The FOMC meets approximately every six weeks. (The next meeting is March 22, 2005.) The seven Governors of the Federal Reserve Board and five of the twelve Presidents of the Federal Reserve Banks make up the committee. The Federal Reserve Governors are appointed by the U.S. President and confirmed by the U.S. Senate. The Boards of each Federal Reserve Bank select the presidents of the banks.
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.
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 target federal funds rate, but the discount rate change does not have a very important effect. In this announcement, the discount rate is not changed.
(Note: In January of 2003, the discount rate was changed to a level one percent above the target federal funds rate. The discount rate had been about one-half of a percent less than the target federal funds rate. Technical aspects of borrowing from the Fed were also changed at the same time. The basic functions of monetary policy were 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.
Have students do the following multiple choice activity.