INTRODUCTION

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 December 12, 2012, press release by the Federal Open Market Committee on the current Federal Reserve monetary policy actions and goals.

TASK

  • Explain the meaning of the December 12, 2012, 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.
  • Identify the current actions taken by the Federal Reserve to achieve its monetary policy goals.
  • Explain the intended effects of open market operations.

PROCESS

First, a  Review of Recent Monetary Policy History

On December 1, 2008, the Business Cycle Dating Committee of the National Bureau of Economic Research (NBER) declared that the U.S. economy reached a peak in the business cycle in December, 2007, and a recession had begun.

At its December 8, 2008, meeting, the Federal Open Market Committee established the target for the federal funds rate at a range of 0 to 1/4 percent.  This historically low fed funds rate target was aimed directly stimulating the economy through lower interest rates.  The Fed has maintained at this low level for the federal funds rate to this time.

On September 20, 2010, the Business Cycle Dating Committee determined that a trough in business activity occurred in the U.S. economy in June, 2009, and that the recession had ended.

After the "official" end of the recession, the FOMC's target for the federal funds rate has not changed.  Other strategies to improve banking system liquidity and stimulate economic growth and employment have been added to the Fed's tool kit.

Students: Are we still in a recession?  What evidence do you have?

Figure 1, below, shows the recent history of the FOMC's federal funds rate target.  Note the straight line at 0-.25 percent since December of 2008.

Figure 1

What did the FOMC have to say, almost four years exactly after pushing its primary tool down to a record low in order to reduce interest rates and stimulate credit markets?

Remember, the primary monetary policy goals of the Federal Reserve, as established by the Employment Act of 1946, are to "promote maximum employment, production, and purchasing power."  In other words, policies should create jobs, increase output, and keep the price level stable.

For information about the Employment Act of 1946, see the Federal Reserve Bank of St.Louis online article, “The Employment Act of 1946: Some History Notes,” by C. J. Santoni (November, 1986).  '

Federal Open Market Committee “Monetary Policy” Statement
Released: December 12, 2012

Note:  Unless otherwise cited, quoted material in this lesson is from the FOMC's December 12, 2012, monetary policy press release.

The FOMC Monetary Policy Announcement

"Information received since the Federal Open Market Committee met in October suggests that economic activity and employment have continued to expand at a moderate pace in recent months, apart from weather-related disruptions. Although the unemployment rate has declined somewhat since the summer, it remains elevated. Household spending has continued to advance, and the housing sector has shown further signs of improvement, but growth in business fixed investment has slowed. Inflation has been running somewhat below the Committee’s longer-run objective, apart from temporary variations that largely reflect fluctuations in energy prices. Longer-term inflation expectations have remained stable."

Students: What does "a moderate pace" mean?  A dictionary defines "moderately" in this context as, "a: tending toward the mean or average amount or dimension;  b: having average or less than average quality : mediocre"

Definition source: Merriam-Webster Online Dictionary, www.merriam-webster.com/dictionary/moderately?show=0&t=1335377457

Students what can happen if the economy grows too slowly and the population continues to grow at a normal pace?

More details from the December 12, 2012, announcement, "Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee remains concerned that, without sufficient policy accommodation, economic growth might not be strong enough to generate sustained improvement in labor market conditions. Furthermore, strains in global financial markets continue to pose significant downside risks to the economic outlook. The Committee also anticipates that inflation over the medium term likely will run at or below its 2 percent objective."

In recent announcements, the FOMC has reiterated its mandate of promoting growth, employment and price stability.  Inthis case, that committment was mad emore specific, as the announcemtn continues.

Inflationary pressures have not been strong enough for the FOMC to choose a higher federal funds rate target.  The trade-off between inflation and growth as potential policy targets has continued to lean toward growth.

What actions will the FOMC take?

"To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee will continue purchasing additional agency mortgage-backed securities at a pace of $40 billion per month. The Committee also will purchase longer-term Treasury securities after its program to extend the average maturity of its holdings of Treasury securities is completed at the end of the year, initially at a pace of $45 billion per month. The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and, in January, will resume rolling over maturing Treasury securities at auction. Taken together, these actions should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative."

The program, "Operation Twist," to purchase longer-term securities as a way to reduce interest rates was continued.  Lower interest rates are intended to be an incenitve for private business investment and home-buying. This announcement maintains the "twist" goals and more.

"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.  Increases in the prices of energy and other commodities have pushed up inflation in recent months."

What is the FOMC Looking For?

"The Committee will closely monitor incoming information on economic and financial developments in coming months. If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until such improvement is achieved in a context of price stability. In determining the size, pace, and composition of its asset purchases, the Committee will, as always, take appropriate account of the likely efficacy and costs of such purchases."

The Federal Funds Rate Target

"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, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored. The Committee views these thresholds as consistent with its earlier date-based guidance. In determining how long to maintain a highly accommodative stance of monetary policy, the Committee will also consider other information, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent."

Something New and More Specific

"The FOMC clarified the timeline and goal for the low interset rate stragegy, "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, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored."

For the first time, the FOMC set a specific unemployment rate target, rather than just setting a general time estimate for the currentl policy goals.  It also clarified the inflation target goal at a maximum of 2.5 percent.  These are much more precise interpretations of the Fed's monetary policy mandate.

Students: Is there any potential problem when the FOMC announces a specific time-frame for the current policy?  Is a less specific statement like "extended period" better?  Some argue that planners, investors, employers, etc., may respond more positively if they know more about future policy.  The specific date may reduce their uncertainty about the economy.  Do you agree or disagree?

The FOMC federal funds rate action was to "keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014."

What Will the Fed Look For in the Future? 

When assessing the health of the economy and the impact of past, current an future monetary policy actions, the FOMC will look closely at GDP growth, employment, unemployment, and other economic data.

Figure 2, below, shows the recent history of growth rates of U.S. real gross domestic product (real GDP).

Figure 2

Students: Is a 2.7 percent real GDP growth rate in Q3 of 2012 enough to really get the U.S. economy growing and increase employment enough?

Figure 3, below, shows the recent monthly history of U.S. unemployment rates.

Figure 3

Students: If the U.S. unemployment rate remains as high as 7-8 percent, how will this potentially impact consumers and producers? 

U.S. output is increasing, although at a slower rate than in the previous quarter (Q4 2011).  The U.S. unemployment rate continues to remain very high.  Look again at Figures 1 and 2.  Can you see the time period of the recession, December, 2007 through June, 2009?

The FOMC has kept the federal funds rate target at a very low level of 0 to .25 percent during the recession and to the present time, but the economy continues to recover very slowly.  Thus, the Fed continues a low interest rate policy that "accommodates" growth.  QE2 (the second round of quantitative easing), purchases of almost $800 billion in securities, intended to provide more market liquidity has officially ended, but continued policies to strengthen the banking system and promote growth continue.

In the past year, the Fed has enacted policies to purchase shorter term securities ad to lengthen the maturity of the Fed's portfolio.  The "Maturity Extension Program and Reinvestment Policy" program is ultimately intended to increase bank lending.

Is there a threat of inflation?  Take a look at the recent history of changes in the price level, as measured by the CPI-U, Figure 4, below.   The majority of the increases and decreases in the price level for the past several months has been energy and food prices.

Figure 4

If you leave out the highly volatile energy (especially gasoline) prices over this time period, there has been very little inflation and occasionally some concern about the prospects for deflation.  Recently, many observers have feared a recurrence of inflation, driven by energy prices and continued government budget deficits.

Students: Are you worried about inflation?  How have higher gasoline prices affected you and your family?

Recent History of the Federal Funds Rate

At it's December 12, 2012, meeting the FOMC decided to keep the target for the federal funds rate at the same level that was first established in December, 2008.  Figure 5, below, shows the history of the federal funds rate from 1990 to the present.  Note the periodic increases and decreases up to December 2008, as the FOMC has sought to influence interest rates to rise and fall in order to reduce inflationary pressures, stimulate growth, or just to keep the price level stable.

Figure 5

Students you can read the FOMC policy statements over the past couple of years to track the beginning and progress of the current recession.  You may note the slight
changes in the statements that signal future direction. 
http://www.federalreserve.gov/monetarypolicy/fomccalendars.htm ]

What Are the Monetary Options?

What can the Fed do with its traditional tools to stabilize the economy?

Stimulatory Policy Actions - usually aimed at promoting economic growth:

  • Buy securities
  • Lower the discount rate
  • Lower bank reserve requirements
     

Contractionary Policy Actions - usually aimed at reducing inflation:

  • Sell securities
  • Raise the discount rate
  • Increase bank reserve requirements
     

How would each of the above policy tools (actions) impact the economy?

Over the past couple of years, the FOMC has been mainly concerned with stabilizing the banking industry and then stimulating business investment and hiring.  The tools for these efforts were discused earlier in this lesson.  The QE 1, QE2, and "Twist" program have been intended to reduce interest rates.  Even with such low interest rates, private investment has been slow and the high unemployment rate remains.

Students: What will it take to get the economy going?  Can the Fed do anything?  What role does the ongoing political stalemate over fiscal policies (taxes and spending) in Congress play?

Students: Is a 6.5 percent unemployment rate within a maximum of 2.5 percent inflation a good overall goal for monetary policy?  Is this the "new normal"?

CONCLUSION

This FOMC monetary policy announcement began with an assessment of current U.S. economic conditions. ""Information received since the Federal Open Market Committee met in October suggests that economic activity and employment have continued to expand at a moderate pace in recent months, apart from weather-related disruptions. Although the unemployment rate has declined somewhat since the summer, it remains elevated. Household spending has continued to advance, and the housing sector has shown further signs of improvement, but growth in business fixed investment has slowed. Inflation has been running somewhat below the Committee’s longer-run objective, apart from temporary variations that largely reflect fluctuations in energy prices. Longer-term inflation expectations have remained stable."."

This FOMC decision was more specific than past announcements.  "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, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.

The FOMC has now specifically targeted a level of unemployment and an inflation limit for the continuation of the "accommodative" policies and actions.  Low interest rates and other  policies to encourage lending and investment are focused directly on the Fed's goals to promote economic growth and full employment, within the goal of minimizing inflation.

As has been the case with recent FOMC meeting announcements, the FOMC has released a video of the press conference, including remarks by Chairman Ben Bernanke,  URL:  www.federalreserve.gov/monetarypolicy/fomcpresconf20121212.htm .

ASSESSMENT ACTIVITY

EXTENSION ACTIVITY

Idea #1.  The Federal Reserve Bank of Philadelphia has published an online activity called "The Case of the Gigantic $100,000 Bill."   In this lesson, students participate in a demonstration of the money creation process using a large $100,000 bill. Expansions of the money supply caused by successive deposits and loans are traded on the board so that students can observe the process. Students learn to calculate the upper bound of the money creation process using the simple money multiplier. 

Go to: The Case of the Gigantic $100,000 Bill.

Idea #2.  The Federal Reserve Bank of San Francisco publishes a website called "The Economy: Crisis and Response," with information about the Fed's policies during the recession and banking crisis. 

Description: "The financial market turmoil that began in 2007 led to a severe global economic downturn. The causes of the crisis, the effects on global financial markets, and the spillover to the economy are examined here."

Go to: The Economy: Crisis and Response and www.federalreserveeducation.org/resources/detail.cfm?r_id=1dfccfb5%2D2336%2D4af5%2Dbe51%2D30720d03681e.