Focus on Economic Data: The U.S. Federal Reserve System and Monetary Policy - December 13, 2005
This lesson printed from:
Posted December 13, 2005
Author: Stephen Buckles
Posted: December 13, 2005
Explore the connection between the economic indicators and real-world issues. These lessons typically can be done in one class period.
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...
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:
Have your students do the following multiple choice activity:
Reasons for a Case Study on the Federal Open Market Committee
Following Federal Open Market Committee announcements, newspapers across the country have front-page stories about Federal Reserve actions to change the target for interest rates and to either boost spending and employment in the U.S. economy or to slow growth in spending. Attention increased as the economy entered a recession in 2001 and then increased again when the Federal Open Market Committee began a series of increases in the target for its federal funds rate in an effort to reduce the stimulus. The announcements reflect serious concerns with the state and direction of the economy and the resulting policy actions.
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 reduce the amount of stimulus that it had been providing the economy. An understanding of monetary policy in action is fundamental to developing a thorough understanding of macroeconomics and the U.S. economy.
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 January 31, 2006.) The seven Governors of the Federal Reserve Board and five of the twelve Presidents of the Federal Reserve Banks make up the committee. The staff of the Federal Reserve implements the recommended policies.
The seven members of the Board of Governors are appointed by the President and confirmed by the Senate to serve 14-year terms of office. Members may serve only one full term, but a member who has been appointed to complete an unexpired term may be reappointed to a full term. The President designates, and the Senate confirms, two members of the Board to be Chairman and Vice Chairman of the Federal Reserve, for four-year terms.
The seven Board members constitute a majority of the 12-member FOMC, the group that makes the key decisions regarding monetary policy. The other five members of the FOMC are Reserve Bank presidents, one of whom is always the president of the Federal Reserve Bank of New York. The other Bank presidents serve one-year terms on a rotating basis. Traditionally, the Chairman of the Board of Governors serves as the Chairman of the FOMC.
The Federal Open Market Committee decided today to raise its target for the federal funds rate by 25 basis points to 4-1/4 percent.
Despite elevated energy prices and hurricane-related disruptions, the expansion in economic activity appears solid. Core inflation has stayed relatively low in recent months and longer-term inflation expectations remain contained. Nevertheless, possible increases in resource utilization as well as elevated energy prices have the potential to add to inflation pressures.
The Committee judges that some further measured policy firming is likely to be needed to keep the risks to the attainment of both sustainable economic growth and price stability roughly in balance. In any event, the Committee will respond to changes in economic prospects as needed to foster these objectives.
Voting for the FOMC monetary policy action were: Alan Greenspan, Chairman; Timothy F. Geithner, Vice Chairman; Susan S. Bies; Roger W. Ferguson, Jr.; Richard W. Fisher; 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 5-1/4 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.
Have your students do the following multiple choice activity:
Guide To Announcement
The Federal Open Market Committee has increased the target for its federal funds rate at each of its meetings since June 2004.
The first paragraph of the announcement summarizes the current monetary policy changes - this month it is the decision to increase the target federal funds rate for the thirteenth meeting in a row - increasing the target from 4.00 percent to 4.25 percent.
The language used to describe the increase assumes an understanding the definition of a basis point. There are 100 basis points in one percent of interest. Thus, an increase of 25 basis points is equal to one-quarter of one percent.
In the second and third paragraphs, the reasoning behind the decision is presented.
In the second paragraph, reference is made to negative economic effects of the damage done by the hurricanes in the southeastern part of the U.S. and by the high oil prices. Yet, the committee believes the economy continues to expand. The members are not currently concerned with inflationary pressure. However, the economy has faced higher energy prices and may be approaching a higher utilization of its capacity – both of which may increase inflationary pressures in the future.
In the third paragraph, the committee indicates that the risks are balanced between inflation (“price stability”) and sustainable economic growth. This means that the chances of increased inflation and chances of a slowdown in the economic growth are about equal. However, in order to maintain that balance, the committee believes that it will need to continue its increases in the target federal funds rate in the future. The term measured has been interpreted to mean gradual increases – for example, ¼ of a percent.
The final sentence in the third paragraph is added simply to reassure analysts that if expectations of inflation change, the FOMC will change its policy quickly and increase the target for the federal funds rate more rapidly. If increased inflationary pressure appear, the FOMC is likely to increase the target federal funds rate more rapidly. If growth in spending in the economy were to slow, the FOMC would be likely to decrease the target.
The fourth paragraph describes the votes of the FOMC members on changing the target for the federal funds rate. In the past, there has been a lag between the announcement of the policy and the publication of this information about votes. This change, which was implemented a little over two years ago, is one step in a FOMC trend toward releasing more information immediately following their meetings. All members of the FOMC voted to leave the target federal funds rate unchanged.
The Federal Reserve Board of Governors actually sets another interest rate known as the discount rate. This is the focus of the fifth paragraph. The process is one of approving requests for a change received from the twelve Federal Reserve Banks. In this announcement, the discount rate is increased by ¼ of one percent to a level of 5 percent. More discussion of the discount rate follows below.
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. See the first figure showing changes in the target. (The periods of the 1990-1991 recession and the 2001 recession are shown in gray on the graph.)
Then as inflationary pressures began to increase in 1994, the Federal Reserve began to raise rates. In response to increased inflationary pressures once again in 1999, the Federal Reserve raised rates six times from June 1999 through May of 2000. Those changes are obvious in the graph.
Growth began to slow at the end of 2000. The slowing growth was one indication of the need for a change in monetary policy that would boost spending in the economy. The FOMC responded by cutting the target federal funds rate throughout the year.
Then as the economy began to recover from the recession and the FOMC turned to concerns that the economy did not need as much stimulation, a series of “measured” increases in the target were undertaken and are continuing with the current increase.
Tools of the Federal Reserve
The Federal Reserve buys and sells bonds and by doing so, increases or decreases banks' reserves and banks’ abilities to make loans. As banks increase or decrease loans, the nation's money supply increases or decreases. That, in turn, decreases or increases interest rates. The purchase and sale of bonds by the Federal Reserve is called open market operations. The Federal Reserve is “operating”, that is buying or selling, in the “open market” for U.S. Treasury securities.
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 opposite occurs when the Federal Reserve buys a bond. The Federal Reserve gives a check to the seller of the bond. The seller deposits the check in their account. Their bank adds to the amount to the deposits and thus the money supply increases. The bank also presents the check back to the Federal Reserve, which in turn adds the amount to the bank’s reserves. Because the bank has to keep only a portion of those reserves, the bank makes loans with the remainder. Thus the money supply expands even further. As banks attempt to make more loans, interest rates fall.
Open market operations are the primary tool of the Federal Reserve. It is a tool that is often used and is quite powerful. This is what the Federal Reserve actually does when it announces a new target for its 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 because the Federal Reserve has sold bonds, that interest rate is likely to increase. If the supply of reserves is increased because the Federal Reserve has purchased bonds, that interest rate is likely to decrease.
Banks earn profits by accepting deposits and lending part 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.
The Federal Reserve also has two other tools that may be used to influence the expansion of and contraction in the money supply.
The Discount Rate
The discount rate is the interest rate the Federal Reserve charges banks if banks borrow reserves from the Federal Reserve itself. Banks may need to borrow reserves if they have made too many loans, have experienced withdrawals of deposits or currency, or have had fewer deposits than they expected.
In reality, banks seldom borrow reserves from the Federal Reserve and tend to rely more on borrowing reserves from other banks when they are needed. They will still pay an interest rate (the federal funds rate), but that is a rate determined in the market for reserves and influenced by the open market operations of the Federal Reserve.
The discount rate is most often changed along with the target for the federal funds rate, but the discount rate change does not have a very important effect as so few banks actually use that means of borrowing reserves. In this announcement, the discount rate is increased along with the federal funds rate.
Figure 2 shows the discount rate along with the federal funds rate. Notice that the discount rate typically changes along with the target for the federal funds rate. Prior to 2003, the discount rate was below the target federal funds rate. Since then the discount rate has been one percent above the target federal funds rate. That is an additional reason that there is little current borrowing of reserves directly from the Federal Reserve.
Banks are required to hold a portion of some of their deposits in reserves. The portion varies depending upon the type of deposits and the size of the bank. Most are required to have either 3 or 10 percent of their deposits on reserve. Reserves consist of the amount of currency that a bank holds in its vaults and the bank’s 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 reserve requirement is seldom changed, but it has a potentially very large effect on the ability to make loans and thus on interest rates.
How does Monetary Policy Work?
Monetary policy works by affecting the amount of money that is circulating in the economy, the level of interest rates, and changes in spending. 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 Reserve’s check in her bank account. The bank’s deposits and reserves increase. The bank then has an increased ability to make 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, machines, and tools, total spending increases. Consumer spending that partially depends upon levels of interest rates (automobile and appliances, for example) is also affected. Output and employment. In this case, unemployment will fall. There may also be some upward pressure on prices.
When the Federal Reserve adopts a restrictive monetary policy, it sells bonds in order to reduce the money supply. This results in higher interest rates and less spending. A restrictive monetary policy will decrease inflationary pressures, but it may also decrease investment spending and real gross domestic product. (See the Inflation Case Study for a more detailed discussion of inflation.)
Have your students do the following multiple choice activity:
Comparison of Monetary and Fiscal Policy
The FOMC reacts to a slowing economy by expanding the money supply, lowering interest rates, and creating increased spending. The reaction to increasing inflationary pressures is to decrease the money supply, raise interest rates, and thereby slowing growth in spending.
Fiscal policy is the taxing and spending policies of the federal government. Those policies also have the potential to influence economic conditions whether deliberately or as an unintended consequence. If the economy is entering a recession, fiscal policy response might be to increase government spending and to lower taxes. If spending in the economy is growing too rapidly, the fiscal response might be to decrease government spending and to increase taxes.
In those processes, there will be debates in Congress about what to do with spending and taxes in order to stimulate or slow overall spending in the economy. These debates normally take a substantial amount of time. This lag points to one of the key differences between fiscal and monetary policy. Fiscal policy is much more difficult to implement but once the decision is made, it takes effect quickly. Monetary policy decisions are much easier to institute and more responsive to economic conditions, but actually take longer to change spending once the decision is made.
What are the Federal Reserve current observations and concerns?
[1.The Federal Reserve believes that the economy is growing without significant inflationary pressure. It goal is to remove the stimulative pressure created by low interest rates. It is implying that it will continue the gradual increases in the target of the federal funds rate.]
What tool will the Federal Reserve use to accomplish its goals?
[The Federal Reserve can buy or sell U.S. Treasury bonds, which in turn will lower or increase the federal funds rate. To reduce the stimulative effects of recent policy, the FOMC is increasing the target for the federal funds rate. That means that the Federal Reserve is selling bonds. (Or it means that the Federal Reserve is slowing the growth of the money supply by purchasing fewer bonds.)]
If the Federal Reserve were to become concerned about a slowing of the 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.]
How do changes in monetary policy affect your family’s spending and business spending in the economy?
[If the Federal Reserve is purchasing bonds, banks will have greater reserves due to increased deposits. With the increased reserves, they can increase the number and size of loans. The increase in loans and the resulting lower interest rates encourage business (and consumer) borrowing and spending. The increased spending in the economy should result in increased business production and employment.]