Focus on Economic Data: The Federal Reserve and Monetary Policy, March 15, 2011
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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 zero to 1/4 percent since its December 16, 2008 meeting. The fed funds rate has been kept at this historically low level due to a long period of low and often negative real GDP growth, record numbers of non-farm employment losses, and a persistently high unemployment rate.
This lesson focuses on the March 15, 2011, press release by the Federal Open Market Committee on the current Federal Reserve monetary policy actions and goals.
- Explain the meaning of the March 15, 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.
The Federal Open Market Committee (FOMC) of the Federal Reserve System has maintained the target for the federal funds rate at a range of zero to 1/4 percent since December 16, 2008. This historically low target was intended at the time to provide the liquidity and low interest rates to stimulate the economy at the beginning of the recession.
Since that time, the FOMC has kept the federal funds rate very low and has provided additional stabilization and stimulus through a variety of programs intended to improve the balance sheets of banks and liquidity in credit markets. The Fed has purchased hundreds of billions of dollars of securities through "quantitative easing" programs referred to as "QE," and more recently, a second round, commonly referred to as "QE2."
At its most recent meeting, the FOMC reiterated its commitment to economic stimulus.
Board of Governors of the Federal Reserve System
Federal Open Market Committee
March 15, 2011
"Information received since the Federal Open Market Committee met in January suggests that the economic recovery is on a firmer footing, and overall conditions in the labor market appear to be improving gradually. Household spending and business investment in equipment and software continue to expand. However, investment in nonresidential structures is still weak, and the housing sector continues to be depressed. Commodity prices have risen significantly since the summer, and concerns about global supplies of crude oil have contributed to a sharp run-up in oil prices in recent weeks. Nonetheless, longer-term inflation expectations have remained stable, and measures of underlying inflation have been subdued."
The statement began with FOMC's broad view of the U.S. economy, referring to the events and changes since the last FOMC meeting. In this case, a more optimistic view than in the past year, using the phrase "on a firmer footing."
The next section of the statement reaffirmed the FOMC's commitment to its Congressional mandate, to maintain a stable price level, economic growth, and full employment. This mandate was first established by a federal law, the "Employment Act of 1946."
"Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. Currently, the unemployment rate remains elevated, and measures of underlying inflation continue to be somewhat low, relative to levels that the Committee judges to be consistent, over the longer run, with its dual mandate. The recent increases in the prices of energy and other commodities are currently putting upward pressure on inflation. The Committee expects these effects to be transitory, but it will pay close attention to the evolution of inflation and inflation expectations. The Committee continues to anticipate a gradual return to higher levels of resource utilization in a context of price stability."
As always, the FOMC made it clear that it was ready to counter any inflationary pressures. In this case, the FOMC recognized the recent high energy and food prices, but did not expect long-term impact, calling them "transitory."
What will the Fed do?
"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 continue expanding its holdings of securities as announced in November. In particular, the Committee is maintaining its existing policy of reinvesting principal payments from its securities holdings and intends to purchase $600 billion of longer-term Treasury securities by the end of the second quarter of 2011. 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."
The Fed will continue to purchase securities to improve the balance sheets of banks and make more funds available for lending. One goal of easing is to increase employment, but the unemployment rate has remained stubbornly high, with some improvement over the past two months.
"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."
There was no new policy action on the federal funds rate target - maintaining the low rates of the past past two years. Again, the recent increases in energy and food prices did not impact Fed policy.
"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."
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 rates 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 change the discount rate as it establishes a target for the federal funds rate.
What happens at a FOMC meeting?
About three weeks after each FOMC meeting, the minutes of the meeting are released. The minutes provide more information about how the meeting’s policy statement was determined and additional factors that were considered. It often provides a more clear indication of future policy options.
Minutes of the Federal Open Market Committee, January 25-26, 2011
"A meeting of the Federal Open Market Committee was held in the offices of the Board of Governors in Washington, D.C., on Tuesday, January 25, 2011, at 1:00 p.m. and continued on Wednesday, January 26, 2011, at 9:00 a.m."
The minutes list the members of the FOMC and all others who were present of the discussion. In this instance, eleven FOMC Committee members were present along with fifty others, representing various Federal Reserve Banks, FRB staff and key operations persons. The new members of the FOMC were officially elected. The meeting was chaired by Ben S. Bernanke, Chairman of the Federal Reserve.
Since the FOMC implements monetary policy primarily through the trading desk of the Federal Reserve Bank of New York, at this meeting the FOMC unauthorized the FRB New York “to the extent necessary to carry out the most recent domestic policy directive adopted at a meeting of the Committee.” This included authorization to “buy or sell U.S. government securities."
All of these authorizations are required by law under the Federal Reserve Act. In addition, the minutes reflect the authorization of the FRB New York to undertake actions in “exceptional circumstances” when directed by the FOMC Chairman to achieve “the Committee's long-run objectives for price stability and sustainable economic growth, and shall be based on economic, financial, and monetary developments during the intermeeting period.” The FOMC then authorized a series of actions concerning the Fed’s purchases and sales of foreign currencies and securities. These actions may impact the value and stability of U.S. currency.
The next part of the meeting was a series of reports from Federal Reserve program managers. The managers report on the progress toward monetary policy goals and issues faced in achieving the goals. Although the FOMC members 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.
For instance, the Manager of the System Open Market Account reported that “achieving a $600 billion expansion of the SOMA portfolio by the end of June 2011 would require purchasing the additional securities at a pace of about $80 billion per month.” In other words, the Fed has to purchase more securities by June to achieve the goal.
A staff presentation on structural unemployment cited the factors that could affect the level of structural unemployment. They are: demographics, changes in the intensity of job search and worker screening, differences in the geographic locations of potential workers and vacant jobs, and mismatches in characteristics between potential workers and available jobs.
Some participants stressed that certain determinants of the unemployment rate, such as mismatches in the labor market and firms' hiring practices, were both difficult to measure in real time and not directly affected by monetary policy. Others emphasized that in the current situation, monetary policy could still play an important role in reducing unemployment.
Next, a series of staff reports reviewed recent economic activity
- The economic recovery "was firming, though the expansion had not yet been sufficient to bring about a significant improvement in labor market conditions."
- "Consumer spending rose strongly late last year, and the ongoing expansion in business outlays for equipment and software appeared to have been sustained in recent months."
- "Construction activity in both the residential and nonresidential sectors remained weak."
- "Measures of underlying inflation remained subdued and longer-run inflation expectations were stable."
- "Consumer credit started to increase again in October and November after having generally declined since the fall of 2008."
- "Activity in the housing market remained weak in an environment characterized by soft demand, a large inventory of foreclosed or distressed properties on the market, and tight credit conditions for construction loans and mortgages."
- "Real business investment in equipment and software appeared to have increased further in the fourth quarter."
- "The U.S. international trade deficit narrowed slightly in November, as both nominal exports and imports moved up by almost the same amount."
- "Recent indicators of foreign economic activity suggested that the global recovery was strengthening. Much of this strength was centered in the emerging market economies (EMEs)."
What was the response after the last FOMC announcement?
The FOMC staff reported "The decision by the FOMC at its December meeting to maintain the 0 to 1/4 percent target range for the federal funds rate was widely anticipated. Both the accompanying statement and the minutes of the meeting were broadly in line with market expectations and elicited limited price action in financial markets." The staff reported:
- "Broad U.S. stock price indexes rose, on net, over the intermeeting period, extending their recent strong performance; bank stock prices modestly outperformed the broader market."
- "Overall, net debt financing by U.S. nonfinancial corporations was robust in the fourth quarter of 2010. Net issuance of bonds was particularly strong, supported by heavy issuance in both the speculative- and investment-grade sectors."
- "Financing conditions for most types of commercial real estate remained tight over the intermeeting period, and delinquency rates for broad categories of commercial real estate loans stayed elevated."
- "Serious delinquency rates on prime and subprime mortgages flattened out in October and November after having moved down earlier in the year."
- "The broad nominal index of the U.S. dollar declined more than 1 percent over the intermeeting period, depreciating by roughly similar amounts, on average, against the currencies of the AFEs and the EMEs."
A wide-ranging discussion of the staff reports and conditions in the Federal Reserve districts took place. From the meeting minutes, "In the discussion of intermeeting developments and their implications for the outlook, the participants generally expressed greater confidence that the economic recovery would be sustained and would gradually strengthen over coming quarters. Their more positive assessment reflected both the tenor of the incoming economic data and information received from business contacts since the previous meeting. Spending by households picked up noticeably in the fourth quarter, business outlays continued to grow at a moderate pace, and conditions in labor and financial markets improved somewhat over the intermeeting period."
In the end, the FOMC agreed on this statement: "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 execute purchases of longer-term Treasury securities in order to increase the total face value of domestic securities held in the System Open Market Account to approximately $2.6 trillion by the end of June 2011. The Committee also directs the Desk to reinvest 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 bottom line, "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."
Was there more FOMC optimism in March?
In recent times, each FOMC statement has begun with the same line, “Information received since the Federal Open Market Committee met in (referencing the date of the previous meeting)." This opening provides the basic rationale for the meeting decision. The March 15, 2011, statement began, “Information received since the Federal Open Market Committee met in January suggests that the economic recovery is on a firmer footing, and overall conditions in the labor market appear to be improving gradually.” This was the most optimistic sounding introduction in recent times.
Here’s a recent history of this key FOMC language:
- April 28, 2010: “economic activity has continued to strengthen and that the labor market is beginning to improve.”
- June 23, 2010: “the economic recovery is proceeding and that the labor market is improving gradually.”
- August 10, 2010: “the pace of recovery in output and employment has slowed in recent months.”
- September 21, 2010: “the pace of recovery in output and employment has slowed in recent months.”
- November 3, 2010: “the pace of recovery in output and employment continues to be slow.”
- December 14, 2010: “the economic recovery is continuing, though at a rate that has been insufficient to bring down unemployment.”
- January 26, 2011: “the economic recovery is continuing, though at a rate that has been insufficient to bring about a significant improvement in labor market conditions.”
- March 15, 2011: “the economic recovery is on a firmer footing, and overall conditions in the labor market appear to be improving gradually.”
Notice how the language changed from meeting to meeting - mostly a vague accessment. This time there was a more positive statement, including the phrases "on a firmer footing" and "improving gradually."
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.
- The above link will take you to the section on "Monetary Policy." 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.
Federal Reserve Education includes a link to a web page that lists a variety of economic data sources (www.forexhound.com/article/Central_Banks/Fed_Background/Economic_Indicators_By_the_Numbers/69850 , www.federalreserveeducation.org/resources/economic_indicators/ ) and additional links to the current data for each indicator.
To find information about your Federal Reserve System district reserve bank, go to: www.federalreserveeducation.org/about-the-fed/ and click on your region on the map.
[Note to Teachers: Have your students look at the information about their region's Federal Reserve Bank.]