Following the announcement on November 6th, newspapers across the country had front-page stories about the most recent Federal Reserve action to lower interest rates and boost spending and employment in the U.S. economy. The announcement reflects serious concerns with the state and direction of the economy. This lesson is intended to guide students and teachers through an analysis of the actions the Federal Reserve began to take earlier this year in an effort to strengthen the economy. An understanding of the monetary policy in action is fundamental to developing a thorough understanding of macroeconomics and the U.S. economy.

KEY CONCEPTS

Discount Rate, Fiscal Policy, Monetary Policy, Open Market Operations, Reserve Requirements, Savings

Current Key Economic Indicators

as of May 5, 2013

Inflation

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.

Employment and Unemployment

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 GDP

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.

Federal Reserve

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...


Announcement

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

"Heightened uncertainty and concerns about a deterioration in business conditions both here and abroad are damping economic activity. For the foreseeable future, then, 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."

"Although the necessary reallocation of resources to enhance security may restrain advances in productivity for a time, the long-term prospects for productivity growth and the economy remain favorable and should become evident once the unusual forces restraining demand abate."

"In taking the discount rate action, the Federal Reserve Board approved the request submitted by the Board of Directors of the Federal Reserve Bank of Richmond."

This press release is available at: www.federalreserve.gov/boarddocs/press/general/2001/20011106/default.htm

Reasons For A Case Study On The Federal Reserve Open Market Committee

Following the announcement on November 6th, newspapers across the country had front-page stories about the most recent Federal Reserve action to lower interest rates and boost spending and employment in the U.S. economy. The announcement reflects serious concerns with the state and direction of the economy. This case study is intended to guide students and teachers through an analysis of the actions the Federal Reserve began to take earlier this year in an effort to strengthen the economy. An understanding of the monetary policy in action is fundamental to developing a thorough understanding of macroeconomics and the U.S. economy.

Guide To Announcement

From January 3 to October 2 of this year, the Federal Reserve Open Market Committee (FOMC) lowered the target federal funds rate from 6.50 percent to 2.50 percent. The announcement on November 6 lowers the rate once more and marks the tenth time that it was lowered in response to concerns of slowing growth in spending and the possibility of a recession. The target federal funds rate is now at its lowest level in forty years.

The FOMC establishes monetary policy. The first paragraph of the announcement summarizes the current policy changes - the decision to lower the target federal funds rate by one-half of a percentage point. (There are 100 basis points in one percent. Fifty basis points equals one-half of one percent). The Federal Reserve Board of Governors also sets 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.

In the second paragraph, the Federal Reserve discusses the reasoning behind changes in monetary policy. The board expresses concern about the state of both the domestic and global economy. With these economic concerns in mind, the Federal Reserve believes the best way to maintain stable prices and sustain economic growth is a further reduction in the target interest rate. This paragraph also indicates that continued economic weakness in the coming months may necessitate further reductions in the target federal funds rate.

The Federal Reserve indicates in the third paragraph that increases in expenditures for homeland security may adversely affect the growth rate of productivity. This is the result of businesses devoting some resources for security measures, thereby raising the costs of production of a wide variety of products. However, the Federal Reserve's long run outlook for productivity growth and the state of economy remains optimistic.

The final paragraph refers to the request by Federal Reserve Bank of Richmond to the Board of Governors of the Federal Reserve System to lower the discount rate by one-half of a percentage point.

The Target Federal Funds Rate and the Discount Rate

You may wish to use the following larger versions of the graphs and tables from this lesson for overhead projection or handouts in class:

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

The rate of growth in real GDP has been increasing over the last several years, but began to slow in the middle of last year. Changes in real GDP at annual rates were 2.3, 5.7, 1.3, and 1.9 percent for each quarter of 2000. During the first three quarters of 2001, GDP grew at an annual rate of 1.3, 0.3 and -0.4 percent respectively. The slowing growth over the past four quarters, relative to the last several years, has been one indicator of the need to use a monetary policy that will boost spending in the economy and help to avoid a recession. (For more on changes in the rate of growth of real GDP and a potential recession, see the most recent GDP Case Study.)

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 December 11th followed by one on January 29 and 30,). Seven Governors of the Federal Reserve Board and five of the twelve Presidents of the Federal Reserve Banks make up the committee. Governors are appointed by the U.S. President and confirmed by the U.S. Senate. Presidents of the Federal Reserve Banks are selected by the Boards of each Bank.

Monetary policy works by affecting the amount of money that is circulating in the economy. 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 Reserves' check in her bank account. As a bank's reserves increase, it has an increased ability to make more 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, 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. If growth in spending exceeds growth in capacity, inflationary pressures tend to emerge. If growth in spending is less than the growth in capacity, then the economy will not be producing as much as it could. As a result, unemployment may rise.

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 inflationary pressures, but it may also decrease investment and real gross domestic product. See the inflation case study for a more detailed discussion of inflation.

How long does it take monetary policy to have an effect on the economy?

[Businesses and consumers do not normally change their spending plans immediately upon an interest rate change. Businesses must reevaluate, make new decisions and order reductions or expansions in production and expenditures. This means that months pass before spending is affected. Monetary policy typically has a short policy lag (the time it takes to create and implement policy) and a long expenditure lag (the time it takes businesses and consumers to adjust to the new interest rates). The total lag time is usually 9-12 months and varies a good bit. Thus when the Federal Reserve changes interest rates now, their decisions will affect economic conditions in approximately a year from the time of the change.

Fiscal policy (changing taxes and government spending) also has a significant lag time. It typically has a long policy lag (the time it takes Congress to approve a tax or spending change) and a short expenditure lag (the time it takes consumers to experience the tax changes and government to change spending). The combined lags may be anywhere from one to almost five years.]

Federal Reserve Goals

The stated goals of the Federal Reserve Open Market Committee are to maintain price stability and sustainable economic growth. (See the second paragraph of the announcement.) The price stability goal 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 changes in technology, the amount and quality of labor and the amount of capital - machines, factories, computers, and inventories.

Tools of the Federal Reserve

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. Reserves consist of the amount of currency that a bank holds in its vaults and its 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 excess reserves. The requirement is seldom changed, but it is potentially very powerful.

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. As banks increase or decrease loans, the nation's money supply changes. That, in turn, decreases or increases interest rates. Open market operations are the primary tool of the Federal Reserve. They are often used and are quite powerful. This is what the Federal Reserve actually does when it announces a new target 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, that interest rate is likely to increase.

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.

Discount Rate:

The discount rate is the interest rate the Federal Reserve charges banks if banks borrow reserves from the Federal Reserve itself. Banks seldom borrow reserves 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.

For more background on the Federal Reserve and resources to use in the classroom, go to www.federalreserve.gov .

How often does the Federal Reserve engage in open market operations?

[The Federal Reserve engages in open market operations on a daily basis - not just when they change the target federal funds rate. The amount of money that banks hold in reserves changes throughout the year and the Federal Reserve will buy or sell bonds to maintain the target federal funds rate at the desired level.]

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" (named for its beige cover) two weeks prior to each meeting of the Federal Reserve Open Market Committee. The following is an excerpt from the Beige Book released on October 24, 2001, in preparation for the meeting on November 6, 2001.

"Reports from all Federal Reserve Districts indicate weak economic activity in September and the first weeks of October. In all Districts, the tragedy of September 11 was followed by a short period of sharply reduced activity. Business activity recovered quickly from some aspects of the shock, such as reduced air cargo capacity, but longer-run effects are more difficult to assess. Retail sales, other than autos, were slightly lower than before September 11, but this weakness might have already been in train. The same is true for manufacturing. Insurance premiums have increased, and security precautions are disrupting productivity.

"Retail sales softened in September and early October in almost all Districts. Auto sales fell at the beginning of the period but have now rebounded following new zero-financing incentive plans. Both shipments and orders for a broad spectrum of manufactured goods, ranging from steel to semiconductors, are weak in most of the country. Construction generally slowed during the period. The softness in consumer spending, manufacturing, and construction is affecting the labor market, where layoffs and plant closings have been reported in many industries, from financial services on the East Coast to media and advertising on the West Coast to auto parts in the central states. There has been little upward pressure on either wages or prices, and, in some cases, they have actually fallen. Dallas and San Francisco also report an increase in health care costs.

"Most Districts report steady or declining consumer prices. Districts reporting steady retail prices included Kansas City and Richmond. Districts reporting lower retail prices included Atlanta, Boston, Chicago, and Dallas. Input prices are reported as decreasing or holding steady, except in Cleveland, where they were mixed."

The Beige Book report can be found at: www.federalreserve.gov/fomc/BeigeBook/2001/20011024/default.htm

From this summary several important trends can be noted.

  1. Most of the Federal Reserve Bank regions are noting slower growth or actual reductions in spending.
  2. Prices remain stable and some are actually falling in the absence of input price pressures from wages and energy.
  3. Growth in demand for labor has slowed tremendously over the past six months and upward pressure on wages does not seem to exist. Unemployment has increased to 5.4 percent from its low of 3.9 percent last fall. (See the unemployment case study.) The decreased intensity of competition for employees has reduced some of the wage pressures. However, employees are demanding better benefit packages and health costs are rising, both of which increase the costs of labor.
  4. Consumer spending is not growing as rapidly as it was, even with the federal income tax rebates of this summer and early fall. Part of this decrease in growth may be due to falling confidence in future economic conditions and to falling stock prices.

The Federal Reserve And Growth In Real GDP

On October 2, 2001 the FOMC released the following unscheduled statement:

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

"The terrorist attacks have significantly heightened uncertainty in an economy that was already weak. Business and household spending as a consequence are being further damped. Nonetheless, the long-term prospects for productivity growth and the economy remain favorable and should become evident once the unusual forces restraining demand abate.

"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 Boston, New York, Cleveland, Richmond, Atlanta, St. Louis, Kansas City and San Francisco."

This press release is available at: www.federalreserve.gov/BoardDocs/Press/General/2001/20011002/default.htm

Questions

  1. Explain why the Federal Reserve lowered target federal funds rate in October and November 2001.

    [The Federal Open Market Committee press release states there has been deterioration in business conditions over the past few months and that combined with increased uncertainty has weakened the state of the economy. In order to reduce the likelihood of further slowing, the Federal Reserve is undertaking steps to encourage increased spending in the economy.]


  2. Explain why the Federal Reserve raised the target federal funds rate in 1999 and 2000.

    [n 1999 and 2000, spending was growing more rapidly than capacity. In order to prevent the resulting increased inflationary pressures, the Federal Reserve reduced the rate of growth in the money supply and thus caused interest rates to increase.]
  3. How does a change in the target federal funds rate affect spending?

    [If banks have fewer reserves, they cannot make as many loans. The reduction in loans and the resulting higher interest rates discourage business (and consumer) borrowing and spending. If the growth in spending falls, there is less upward pressure on prices. In the case of too little growth or a reduction in spending, the increased availability of loans and lower interest rates may encourage businesses and consumers to increase their spending.]

  4. What are the risks in the Federal Reserve lowering interest rates?

    [The risks are that the economy is slowing and will turn back to a faster rate of growth in spending on its own. If that is the case, the lowering of interest rates may begin to encourage more spending just as the economy begins to recover. That result could add to eventual inflationary pressures.]

Additional question to test understanding:

  1. A role of the Federal Reserve is to maintain the money supply. What is money?

    [The two primary definitions of money are called M1 and M2. The M1 definition of money includes currency, checking account deposits, and traveler's checks. The M2 definition of money includes all of the money in the M1 definition, plus savings deposits, and money market mutual funds.]


  2. How do changes in the target federal funds rate affect GDP?

    [Changes in the federal funds rate will tend to lead to reductions in other short-term interest rates. Changes in interest rates that banks charge for loans and pay on deposits will primarily affect investment expenditures as interest rates are a cost of investing. When interest rates decrease, it is less expensive for businesses to invest. Increases in investment expenditures will increase the amount of capital available for production and eventually the productive capacity of the economy. Consumers also change spending on houses as interest costs change. Consumption spending on appliances and automobiles and other items requiring consumer loans also increase as interest rates fall.

    More advanced: Changes in interest rates also affect the exchange rate. A decrease should lead to a lower international value of the U.S. dollar (assuming other interest rates around the world do not change). Therefore, imports will decrease and exports will increase.]

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" consists of the reports of the economic conditions in the 12 Federal Reserve Banks across the country. Those data are part of the information considered by the FOMC when it makes its decisions. Refer to the beige book (www.federalreserve.gov/fomc/BeigeBook/2001/20010919/default.htm ) in order to discern the opinions of different workers, industries and retailers. In the current economic slowdown, the following questions might be asked:

Which cities are faring the worst; which are the best?
Which sectors of the economy are faring the worst; which are the best?

The Federal Reserve also has a web-site for economic students located at  www.federalreserveeducation.org/ . Additional information on monetary policy may be found there.