Focus on Economic Data: The Federal Reserve and Monetary Policy, November 3, 2010
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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 target federal funds rate at a range of 0 to 1/4 percent since its December 16, 2008 meeting. The fed funds rate has been kept at this historically low level due to over a year of low and often negative real GDP growth, significant numbers of non-farm employment losses and very high unemployment.
This lesson focuses on the March 16, 2010, press release by the Federal Open Market Committee on the current Federal Reserve monetary policy actions and goals.
- Explain the meaning of the November 3, 2010, 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.
After its regularly scheduled November 2-3, 2010, meeting, the Federal Open Market Committee issued a very negative assessment of the recent health of the U.S. economy. The Fed saw weakness in every sector and describes the economic recovery as "disappointingly slow."
Board of Governors of the Federal Reserve System
Press Release: Monetary Policy
Released: November 3, 2010
"Information received since the Federal Open Market Committee met in September confirms that the pace of recovery in output and employment continues to be slow. Household spending is increasing gradually, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit. Business spending on equipment and software is rising, though less rapidly than earlier in the year, while investment in nonresidential structures continues to be weak. Employers remain reluctant to add to payrolls. Housing starts continue to be depressed. Longer-term inflation expectations have remained stable, but measures of underlying inflation have trended lower in recent quarters."
"Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. Currently, the unemployment rate is elevated, and measures of underlying inflation are somewhat low, relative to levels that the Committee judges to be consistent, over the longer run, with its dual mandate. Although the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, progress toward its objectives has been disappointingly slow."
What are the key data identified by the FOMC?
What is the Fed's strategy?
Expanding its capacity and willingness to pump more liquidity into the economy, the Fed will purchase another $600 billion in U.S. Treasury Securities. With little possibility that the traditional too low lowering the federal funds rate will have any positive impact, the committee kept the target federal funds rate at 0-1/4 percent.
"To promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to expand its holdings of securities. The Committee will maintain its existing policy of reinvesting principal payments from its securities holdings. In addition, the Committee intends to purchase a further $600 billion of longer-term Treasury securities by the end of the second quarter of 2011, a pace of about $75 billion per month. The Committee will regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed to best foster maximum employment and price stability."
How will purchasing Treasury securities help the economy?
Under more "normal" circumstances, the Fed targets short-term interest rates, the federal funds rate, for instance. The strategy of purchasing Treasure securities is intended to impact long-term interest rates. By demanding more Treasury securities, the prices of the securities increase, which, turn, causes their interest rates to fall. Lower rates should result in more borrowing and investment. This is the stated intent of the Fed.
"The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels for the federal funds rate for an extended period."
This statement reaffirms the FOMC's recent stance that targeting the federal funds rate, its traditional policy action, is not longer an effective tool to achieve its goals of price stability, growth and full employment. The Fed funds rate target has been set at zero to 1/4 percent since December 2008 and economic growth continues to be weak. .
"The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to support the economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate."
This policy action does not come without risk, according to Thomas Hoenig, President of the Federal Reserve Bank of Kansas City, the sole member of the FOMC to vote against the policy. Hoenig argued that "continued high level of monetary accommodation increased the risks of future financial imbalances and, over time, would cause an increase in long-term inflation expectations that could destabilize the economy." In other words, the short-term benefits of low interest rates and increased liquidity may result in extreme inflationary pressures in the long-run. Hoenig was outvoted 9 to 1 by the FOMC members.
Read the full November 3, 2010 FOMC Statement .
What if Mr. Hoenig is right? Should the Fed avoid short-term policies that may have serious inflationary imact inthe future?
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 rtaes 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.
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.
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. By purchasing or selling securities, the Fed can influence the level of bank reserves, and thus, the level of the federal funds rate. 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 set the discount rate as it establishes a target for the federal funds rate.
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?
What happens at a FOMC meeting?
After each FOMC meeting and statement, the meeting minutes are prepared and released about three weeks later. The minutes often provide insight into the focus of the meeting and the factors that influenced the FOMC decision. The minutes contain staff reports and committee discussion. As an example, the minutes of the September 21, 2010, FOMC meeting contained these staff comments on economic conditions at that time. The September meeting minutes were released on October 12, 2010.
Though only ten individuals vote at each FOMC meeting, others who provide national data and regional perspectives participate in the meeting. At the September 21 FOMC meeting , over fifty people participated.
Although the governors have broad knowledge of economic conditions, they rely on the staff to provide data that will inform their monetary policy decision. The meeting begins with a staff review on topics, such as labor markets, industrial production, personal consumption and business spending. The following is summarized or quoted from the minutes of the September 21, 2010 meeting.
At the September meeting, the staff summarized that “the pace of the economic expansion slowed in recent months and that inflation remained low. Private businesses increased employment modestly in August, but the length of the workweek was unchanged and the unemployment rate remained elevated.” They continued that inflation was “subdued” despite a recent rise in consumer prices. Other staff reports summarized economic conditions concerning foreign economic activities
The staff then reviewed the situation of financial markets, including an assessment of the impact of the most recent FOMC policy statement. About the federal funds rate impact, they reported, “the expected path of the federal funds rate rose for a time following the more-positive-than-expected data on manufacturing activity and the labor market released in early September, but the path ended the intermeeting period down on balance.”
“Yields on nominal Treasury coupon securities were volatile and ended the period somewhat lower, particularly for intermediate- and longer-term maturities.”
“Conditions in short-term funding markets continued to improve following the recent stresses related to concerns about financial stability in Europe.
“Broad U.S. stock price indexes edged up, on balance, over the intermeeting period, and option-implied volatility on the S&P 500 index was little changed on net.”
“Net debt financing by U.S. nonfinancial corporations remained robust in August.”
“Commercial real estate markets continued to face difficult financial conditions, although some further signs emerged that this sector might be stabilizing. The prices of commercial properties appeared to have edged up in the first half of the year, and the volume of commercial real estate sales rose again in August.“
“For households, record-low mortgage rates supported a relatively high level of refinancing activity, but many borrowers reportedly remained unable to refinance because of insufficient home equity or poor credit histories.”
“Bank credit expanded in August, reflecting significant purchases of Treasury securities and agency MBS by large banks. Bank loans continued to contract, but the pace of contraction slowed noticeably from earlier in the year.”
The staff provided its economic outlook. “In the economic forecast prepared for the September FOMC meeting, the staff lowered its projection for the increase in real economic activity over the second half of 2010. The staff also reduced slightly its forecast of growth next year but continued to anticipate a moderate strengthening of the expansion in 2011 as well as a further pickup in economic growth in 2012.”
“Overall inflation was projected to remain subdued, with the staff's forecasts for headline and core inflation little changed from the previous projection.”
Which of these staff comments (above) supports the policy options chosen by the FOMC?
FOMC Participants' Views on Current Conditions and the Economic Outlook
“In their discussion of the economic situation and outlook, meeting participants generally agreed that the incoming data indicated that output and employment were increasing only slowly and at rates well below those recorded earlier in the year. Although participants considered it unlikely that the economy would reenter a recession, many expressed concern that output growth, and the associated progress in reducing the level of unemployment, could be slow for some time. Participants noted a number of factors that were restraining growth, including low levels of household and business confidence, heightened risk aversion, and the still weak financial conditions of some households and small firms. A few participants noted that economic recoveries were often uneven and were typically slow following downturns triggered by financial crises. A number of participants observed that the sluggish pace of growth and continued high levels of slack left the economy exposed to potential negative shocks. Nevertheless, participants judged the economic recovery to be continuing and generally expected growth to pick up gradually next year.”
“A number of participants noted that the current sluggish pace of employment growth was insufficient to reduce unemployment at a satisfactory pace. Several participants reported feedback from business contacts who were delaying hiring until the economic and regulatory outlook became more certain.”
“Inflation had declined since the start of the recession, and most participants indicated that underlying inflation was at levels somewhat below those that they judged to be consistent with the Committee's dual mandate for maximum employment and price stability. Although prices of some commodities and imported goods had risen recently, many business contacts reported that they currently had little pricing power and that they anticipated limited, if any, increases in labor costs.”
The FOMC Members Agree on a Policy Action Statement
The minutes reported, “In their discussion of monetary policy for the period immediately ahead, nearly all of the Committee members agreed that it would be appropriate to maintain the target range for the federal funds rate of 0 to 1/4 percent and to leave unchanged the level of the combined holdings of Treasury, agency debt, and agency mortgage-backed securities in the SOMA (System Open Market Account).
“At the conclusion of the discussion, the Committee voted to authorize and direct the Federal Reserve Bank of New York, until it was instructed otherwise, to execute transactions in the System Account in accordance with the following domestic policy directive:
"The Federal Open Market Committee seeks monetary and financial conditions that will foster price stability and promote sustainable growth in output. To further its long-run objectives, the Committee seeks conditions in reserve markets consistent with federal funds trading in a range from 0 to 1/4 percent. The Committee directs the Desk to maintain the total face value of domestic securities held in the System Open Market Account at approximately $2 trillion by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities. The System Open Market Account Manager and the Secretary will keep the Committee informed of ongoing developments regarding the System's balance sheet that could affect the attainment over time of the Committee's objectives of maximum employment and price stability."
The last action was to vote on the policy statement to be included in the press release. This statement was the focus of the September 21, 2010, Focus on Economic Data “Employment and the Unemployment Rate” lesson.
To read the complete September 21 FOMC meeting minutes .
The November 3, 2010, FOMC monetary policy statement confirmed what many economists, analysts, and news commentators expected, no change in the federal funds rate target. With no anticipation of inflationary pressures, the FOMC decided that low interest rates are not enough to stiulate economic activity, and that purchases of Treasury securities is warranted improvement in the U.S. economy.
One question often discussed among economists and financial professionals is when the Fed will reverse course and increase the fed funds rate - with the goal of increasing interest rates. Most agree that signs of inflationary pressures will cause the FOMC to raise rates. The FOMC has made it clear that little inflationary pressure currently exists. Resource utilization is low and resource prices are stable if not decreasing.
Energy prices may be the wide card, as oil prices have recently increased. If energy demand is a result of growth, 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.
Is this FOMC statement good news or not?
Next, answer the essay question on the interactive notepad.
1. What is the purpose of the FOMC's target for the federal funds rate?
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.
- Click on the link to "Monetary Policy." Click on the link and review the "Basics of Monetary Policy."
- Click on "How does the Fed create money?" to learn how Fed actions can influence the money supply.
- 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.
Fed 101 includes a link to a web page that lists twelve National Economic Indicators and additional links to the current data for each indicator.