Online Lesson

Focus on Economic Data: The Federal Reserve System and Monetary Policy - May 2001

Announcement:

"The Federal Open Market Committee at its meeting today decided to lower its target for the federal funds rate by 50 basis points to 4 percent. In a related action, the Board of Governors approved a 50 basis point reduction in the discount rate to 3-1/2 percent."

"A significant reduction in excess inventories seems well advanced. Consumption and housing expenditures have held up reasonably well, though activity in these areas has flattened recently. Investment in capital equipment, however, has continued to decline. The erosion in current and prospective profitability, in combination with considerable uncertainty about the business outlook, seems likely to hold down capital spending going forward. This potential restraint, together with the possible effects of earlier reductions in equity wealth on consumption and the risk of slower growth abroad, continues to weigh on the economy."

"With pressures on labor and product markets easing, inflation is expected to remain contained. Although measured productivity growth stalled in the first quarter, the impressive underlying rate of increase that developed in recent years appears to be largely intact, supporting longer-term prospects."

"The Committee continues to believe that 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 in the foreseeable future."

"In taking the discount rate action, the Federal Reserve Board approved requests submitted by the Boards of Directors of the Federal Reserve Banks of New York, Richmond, Chicago, St. Louis and San Francisco."

Guide to the Announcement:

This is the fifth one-half percentage point decrease in the target federal funds rate this year, as the Federal Reserve Open Market Committee continues to be concerned with slowing growth in spending and the possibility of a recession.

The first paragraph of the announcement summarizes the policy changes. The Federal Open Market Committee sets monetary policy. The committee is changing monetary policy so that the federal funds rate falls by one-half of a percentage point. (There are 100 basis points in one percent.) The Federal Reserve Board of Governors decides on the discount rate, through a technical process of approving requests of the twelve Federal Reserve Banks. (See the last paragraph of the announcement.) The discount rate was also lowered by one-half of one percent.

The second and third paragraphs are the core of the announcement. The second paragraph implies that businesses have reduced inventories that increased as the rate of growth in consumer and investment spending decreased. Consumption spending and new housing continue to grow, but slowly. Investment spending by businesses is decreasing and the Federal Reserve expects that decrease to continue. Declining profits and economic uncertainty have caused the investment spending to decrease. The decrease in stock prices has likely caused consumers to reduce the rate of increase in their spending and may continue to do so in the future. In addition, economies in other countries around the world may grow more slowly and that will put further downward pressures on their purchases of our exports.

The third paragraph indicates that the committee is not concerned with inflationary pressures. Increases in demand in goods and labor markets are not larger than increases in supply. In fact, during the last month claims for unemployment insurance reached their highest point in five years. And unemployment in April went to 4.5% from 4.3% in March.

Productivity fell slightly in the first quarter. See the Productivity case study. The committee does not believe that this a permanent change in productivity growth and believes that the rapid increase of the last few years will continue.

The fourth paragraph provides an indication of the longer-run strategy of the Open Market Committee. While this statement is no guarantee, it is an indication the committee members believe further lowering of interest rates will be necessary.

The final paragraph refers to the technical requests by Federal Reserve Banks to the Board of Governors of the Federal Reserve System to lower the discount rate by one-half of percentage point.

Data Trends:

The Federal Reserve 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 in 1999, the Federal Reserve raised rates six times from June 1999 through May of 2000.

On January 3, January 31, March 20, April 18, 2001, the Federal Reserve lowered the target federal funds rate - by a total of a two percent, from 6.50 percent to 4.50 percent. The current announcement reports that the Federal Reserve lowered the target federal funds rate another 50 basis points to 4.00 percent. This is the lowest target federal funds rate since April 1994. (There are 100 basis points in one percent. Fifty basis points equals one-half of one percent.)

While the rate of growth in real GDP has been increasing over the last several years, real GDP has increased at annual rates of 4.8, 5.6, 2.2, and 1.0 percent for each quarter of 2000. During the first quarter of 2001, GDP grew at an annual rate of 2.0%. (This increase over the last quarter of 2000 is a bit of good news. But one should be cautious about inferring too much from a single quarter's change.) This slowing growth of the least three quarters, relative to the last several years, has been one indicator of the need to use a monetary policy that will assist the economy in growing more rapidly and in avoiding a recession - an actual fall in real GDP. For more on recent changes in the rate of growth of real GDP, see the most recent GDP Case Study.

Federal Open Markets Committee (FOMC):

The FOMC meets about every six weeks. The Committee consists of the seven Governors of the Federal Reserve Board and five of the twelve Presidents of the Federal Reserve Banks. Governors are appointed by the U.S. President and confirmed by the US Senate. The Presidents of the Federal Reserve Banks are selected by the Boards of each Bank. The primary function of the FOMC is to direct monetary policy for the US economy.

Monetary policy works by affecting the amount of money that is circulating in the economy. By buying or selling existing US Treasury bonds, the Federal Reserve is able to change the amount of money that banks are holding in accounts. If the Federal Reserve buys a bond, the seller deposits the Federal Reserves' check in her account, and the amount of money in the economy increases. Banks can make more loans, because their deposits have increased.

The effects on the economy are that loans are easier to obtain. And there is a tendency for interest rates to fall. 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, appliances, etc.) 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. 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 inflation, but it may also decrease investment and real gross domestic product.

Federal Reserve Goals:

The stated goals of the Federal Reserve Open Market Committee are to maintain price stability and sustainable economic growth. That means that the Federal Reserve will try to minimize inflation or at least hold inflation to an amount that will not change most peoples' decisions. For all practical purposes, that rate has been between about 2 to 4 percent in recent years.

The goal of sustainable economic growth translates into holding the growth in spending to a level that equals the growth in our capacity. The latter is determined by technology, the amount of labor and the amount of capital - machines, factories, computers, and inventories. If growth in spending exceeds growth in capacity, inflationary pressures tend to emerge. If growth in spending is below growth in capacity, unemployment may rise and the economy will not be producing as much as it could.

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, increases or decreases the nation's money supply, and decreases or increases interest rates. This is the primary tool of the Federal Reserve. It is often used and is quite powerful. This is what the Federal Reserve actually does when it announces a new target federal funds rate.

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 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 rates is likely to increase.

Discount rate -

The discount rate is the interest rate the Federal Reserve charges banks if they borrow reserves from the Federal Reserve itself. Banks do not borrow reserves in significant amounts 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 as it is in this announcement, but the change does not have a very important effect.

Reserve requirements -

Banks are required to hold a portion (either 10 or 3 percent, depending upon the size of the bank) of some of their deposits in reserve. If they have more reserves than they are required to have, banks 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 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 .

The Beige Book - A Survey of Current Economic Conditions:

The Federal Reserve's report on economic conditions across the country is released in the "Beige Book" prior to each meeting of the Federal Reserve Open Market Committee. The following is an excerpt from the Beige Book released on May 2, 2001, in preparation for its meeting on May 15, 2001.

"Almost all districts report a slow pace of economic activity in March and early April.

"Retail prices are steady in most districts except Richmond, where retail prices have been rising at a quicker pace in recent weeks. By and large, non-energy input costs are stable, with only a few exceptions. Manufacturing materials prices in the Chicago and Kansas City districts, for example, continue to rise, while construction materials prices in the Minneapolis district have decreased somewhat. The Dallas district is experiencing downward price pressures for metals and high-tech products. The Atlanta and Chicago districts note increases in health insurance costs. Nearly all districts report that energy costs are up sharply, hitting historic highs in some areas. The trucking industry has been hit the hardest by high gasoline prices. Several districts, especially Dallas and San Francisco, report that firms are increasingly passing on these high costs to customers as fuel surcharges. Hikes in electricity costs are concerns in both the Philadelphia and, especially, San Francisco districts.

"Manufacturing activity continues to weaken across districts, with demand having fallen in most industries. Orders and production are down in the Atlanta, Boston, Chicago, Cleveland, Minneapolis, Philadelphia, Richmond and San Francisco districts. Some districts report that excess inventories, which had been growing since the beginning of the year, are starting to fall because of production cuts. In the Boston and San Francisco districts, though, manufacturers still express concerns about excess inventories. The Philadelphia district's manufacturing sector is a mixed bag, with orders down in April, but shipments steady.

"While some districts still mention that labor markets are tight, almost all note that this tightness has been easing, especially in the manufacturing sector. Most contacts in the Atlanta, Boston, Chicago, Kansas City and St. Louis districts have commented that filling vacancies has become easier. The Dallas district, however, reports that quality workers are still elusive, and construction workers are still in short supply in the Chicago and Kansas City districts. Skilled workers in the energy sector are also in short supply in the Kansas City district. The New York district notes a continuing backlog of demand for workers in the financial services industry, though this has become less pronounced in recent weeks. Employment in the St. Louis district's retail trade and service sectors are picking up because of strengthening demand.

"Upward wage pressures have generally abated. Wages are rising very moderately or are unchanged in most parts of the country except the Richmond and San Francisco districts, where scattered wage increases are noted."

From this summary several important trends can be noted.

1. Prices remain stable, with the exception of energy and fuel related products. Companies in fuel intensive industries who have been absorbing the increasing costs of fuel and energy are beginning to pass them on to consumers in the form of higher prices.
2. Growth in demand for labor is slowing and the upward pressure on wages is abating. Unemployment has increased to 4.5% (See the key economic indicators on the first page.) from its low of 3.9% last fall. The decreased intensity of competition for employees has reduced some of the wage pressures. However, unemployment varies by industry and skilled workers are still in short supply.
3. Consumer spending is not growing as rapidly as it was. Part of this decrease in growth rates is due to falling confidence in the future and to falling stock prices.
4. Excess inventories are falling due to discounting and reductions in production. There is still some concern with rising excess inventories in parts of the country.
5. Most of the Federal Reserve Bank regions are noting slower growth in spending.

The Federal Reserve and Growth in Real GDP:

On March 20, 2001 The FOMC released the following statement (slightly edited):

"The Federal Open Market Committee at its meeting today decided to lower its target for the federal funds rate by 50 basis points to 5 percent. In a related action, the Board of Governors approved a 50 basis point reduction in the discount rate to 4-1/2 percent.

"Persistent pressures on profit margins are restraining investment spending and, through declines in equity wealth, consumption. The associated backup in inventories has induced a rapid response in manufacturing output and, with spending having firmed a bit since last year, inventory adjustment appears to be well underway.

"Although current developments do not appear to have materially diminished the prospects for long-term growth in productivity, excess productive capacity has emerged recently. The possibility that this excess could continue for some time and the potential for weakness in global economic conditions suggest substantial risks that demand and production could remain soft. In these circumstances, when the economic situation could be evolving rapidly, the Federal Reserve will need to monitor developments closely.

"The Committee continues to believe that 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 in the foreseeable future.

"In taking the discount rate action, the Federal Reserve Board approved requests submitted by the Boards of Directors of all twelve Reserve Banks."

On April 18, 2001, the Federal Reserve released the following:

"The Federal Open Market Committee decided today to lower its target for the federal funds rate by 50 basis points to 4-1/2 percent. In a related action, the Board of Governors approved a 50 basis point reduction in the discount rate to 4 percent."

"The FOMC has reviewed prospects for the economy in light of the information that has become available since its March meeting. A significant reduction in excess inventories seems well advanced. Consumption and housing expenditures have held up reasonably well, though activity in these areas has flattened recently. Although measured productivity probably weakened in the first quarter, the impressive underlying rate of increase that developed in recent years appears to be largely intact."

"Nonetheless, capital investment has continued to soften and the persistent erosion in current and expected profitability, in combination with rising uncertainty about the business outlook, seems poised to dampen capital spending going forward. This potential restraint, together with the possible effects of earlier reductions in equity wealth on consumption and the risk of slower growth abroad, threatens to keep the pace of economic activity unacceptably weak. As a consequence, the Committee agreed that an adjustment in the stance of policy is warranted during this extended intermeeting period."

"The Committee continues to believe that 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 in the foreseeable future."

Questions:

1. Explain why the Federal Reserve lowered target federal funds rate in March, April, and May of 2001.
2. Explain why the Federal Reserve raised the target federal funds rate in 1999 and 2000.
3. How does a change in the target federal funds rate affect spending?
4. Monetary policy takes nine to twelve months to have its full effect on spending. Why does monetary policy take so long to work?
5. What are the risks in the Federal Reserve lowering interest rates?

An Activity:

A productive activity is to form a Federal Open Market Committee in your class. Current data and forecasts can be examined. Votes can be taken as to the proper policy. Some roles can be assigned. Bankers, farmers, laborers, stockholders all have opinions and interests in the outcomes of the meetings.

The "beige book" is published about two weeks prior to the meetings of the FOMC. The next publication is June 13 for the June 26/27 FOMC meeting. The "beige book" (called beige because that is the color of the cover) reports on economic conditions around the country. Those data are part of the information considered by the FOMC when it makes its decisions.