Announcement
(an excerpt)

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

The Committee continues to believe that an accommodative stance of monetary policy, coupled with still-robust underlying growth in productivity, is providing important ongoing support to economic activity. However, incoming economic data have tended to confirm that greater uncertainty, in part attributable to heightened geopolitical risks, is currently inhibiting spending, production, and employment. Inflation and inflation expectations remain well contained.

In these circumstances, the Committee believes that today's additional monetary easing should prove helpful as the economy works its way through this current soft spot. With this action, the Committee believes 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 balanced with respect to the prospects for both goals in the foreseeable future.

Voting for the FOMC monetary policy action were Alan Greenspan, Chairman; William J. McDonough, Vice Chairman; Ben S. Bernanke, Susan S. Bies; Roger W. Ferguson, Jr.; Edward M. Gramlich; Jerry L. Jordan; Donald L. Kohn, Robert D. McTeer, Jr.; Mark W. Olson; Anthony M. Santomero, and Gary H. Stern.

This complete press release is available at: www.federalreserve.gov/BoardDocs/Press/monetary/2002/20021106/default.htm

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

Following recent Federal Open Market Committee announcements, newspapers across the country have had front-page stories about the Federal Reserve actions to changeinterest rates and boost spending and employment in the U.S. economy. That attention has only increased as the economy entered a recession beginning in March of last year and real GDP actually fell in the first three quarters of 2001. The announcements reflect serious concerns with the state and direction of the economy. While most economists believe the recession is now over, the economy is still in a fragile state and growth has not returned to the strength of recent years..

This case study is intended to guide students and teachers through an analysis of the actions the Federal Reserve began to take last year and continue to take in an effort to strengthen the economy. An understanding of 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 December 11 of 2001, the Federal Reserve Open Market Committee (FOMC) lowered the target federal funds rate 11 times from 6.50 percent to 1.75 percent (a total reduction of 4.75 percent). This is the lowest target federal funds rate in more than forty years. At all previous 2002 meetings, the FOMC decided to leave the federal funds rate unchanged.

The first paragraph of the announcement summarizes the current monetary policy changes - this month it is the decision to cut the target federal funds rate by 0.5% (There are 100 basis points in one percentage point. Thus a 50 basis point cut is a reduction of 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. The discount rate also was cut by 0.5% (to 0.75%) at this meeting.

In the second and third paragraphs, the Federal Reserve discusses the reasoning behind their decision. The reference to “an accommodative stance” is to the belief by members of the committee that monetary policy is currently encouraging increased spending in the economy. The statement that “incoming economic data have tended to confirm that greater uncertainty, in part attributable to heightened geopolitical risks, is currently inhibiting spending, production, and employment.” refers to the underlying foreign threats and the effects on consumer and investment spending are hampering economic spending. The FOMC indicates that the long-run prospects are good. The FOMC members expect continued productivity growth. However, the first sentence of the third paragraph indicates that additional stimulation of spending through monetary policy will help.

The second sentence of the third paragraph is a standard sentence in most of the FOMC announcements. The last part of that sentence indicates the beliefs about future conditions, given the current actions. In this case, the FOMC announcement states that risks of increased inflation and increased unemployment are balanced. That is, they don’t expect to have to make further changes between now and the next meeting or at the next meeting, unless something else changes.

The fourth paragraph describes the votes of the FOMC members on changing the target federal funds rate. In the past, there has been a lag between the announcement and the publication of this information in the minutes. This change, which was implemented at the March meeting, is one step in a FOMC trend toward releasing more information immediately following their meetings. All members of the FOMC voted to reduce the target federal funds rate.

There has been much recent debate about whether the Federal Reserve should lower rates further and risk inflationary pressures. In the press release, the Fed states that it believes inflation and inflation expectations are well contained. Recent unemployment rates have shown a trend toward stabilization in a range of about 5.6 to 5.7% and real GDP has maintained positive growth for the last four quarters. In the absence of evidence of further slowing in the economy, the decision of the Fed will be scrutinized if inflationary aspects return to the economy in the near future.

The Target Federal Funds Rate and the Discount Rate

 

Data Trends

During the last half of the 1990s, real GDP grew at rates more rapid than those in the first half of the decade. That growth began to slow at the end of 2000. Real GDP increased at annual rates of 4.1 percent and 3.8 percent in 1999 and 2000. During the first three quarters of 2001, real GDP actually decreased. For the year as a whole, real GDP increased only by .3 percent. The slowing growth over the last two quarters of 2000 and the first three quarters of 2001 was one indication of the need to use a monetary policy that would boost spending in the economy. The FOMC responded by cutting the target federal funds rate throughout the year as noted above. During the fourth quarter of 2001, real GDP increased at an annul rate of 2.7 percent. In the first quarter of 2002, real GDP the annual rate of growth increased even more rapidly at a rate of 5.0 percent - evidence that the stimulative monetary policy was having an effect. In the second and third quarters of 2002, real GDP increased at a rates of 1.3 and 3.1 percent. (For more on changes in the rate of growth of real GDP and the current recession, see the most recent GDP Case Study.)

The FOMC used policies actively throughout much of the 1990s. The FOMC had 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.

Recessions

On November 26, 2001, the National Bureau of Economic Research (NBER) announced though its Business Cycle Dating Committee that it had determined that a peak in business activity occurred in March of 2001. That signals the official beginning to a recession.

The NBER defines a recession as a "significant decline in activity spread across the economy, lasting more than a few months, visible in industrial production, employment, real income, and wholesale-retail trade." The current data show a decline in employment, but not as large as in the previous recession. Unemployment has also increased during the period overall. Real income growth slowed but did not decline. Manufacturing and trade sales and industrial production have both declined and now appear to be turning around.

While the common media definition of a recession is two consecutive quarters of decline in real GDP, this recession began before quarterly real GDP actually declined.

The last recession began in July of 1990 and ended in March of 1991, a period of eight months. However, the beginning of the recession was not announced until April of 1991 (after the recession had actually ended). The end of the recession was announced in December of 1992, almost 21 months later. One of the reasons the end of the recession was so difficult to determine was the economy did not grow very rapidly even after it came out a period of falling output and income. That may well be the case today.

Many observers are now stating that the 2001 recession may have ended in December of 2001. The National Bureau of Economic Research has not yet declared the end of the recession.

For the full press release from the National Bureau of Economic Research see: http://cycles-www.nber.org/cycles/november2001/recessnov.html

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 10.) The 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. The Boards of each Federal Reserve Bank select the presidents of the banks.

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. 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.

How often do 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.]

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 along with the discount rate, but the change does not have a very important effect. In this announcement, the discount rate is not changed.

Reserve Requirements:

Banks are required to hold a portion (either 10 or 3 percent of most deposits, 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 what are called 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.

How does Monetary Policy Work?

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 and appliances, for example) 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.

Comparison of Monetary and Fiscal Policy

The FOMC has been reacting to the slowing economy over the past two years. While the monetary policy has not been sufficient to prevent a recession, it surely has made the recession milder than it would have been otherwise and has likely contributed to the recession ending sooner.

Fiscal policy, the taxing and spending policies of the federal government, also has the potential to influence economic conditions. Throughout this year, there have been debates in Congress about what to do with spending and taxes in order to stimulate overall spending in the economy. These debates continue and little has been accomplished. This points to one of the key differences between fiscal and monetary policy. Fiscal policy is much more difficult to implement but takes effect more rapidly once the decision is made. Monetary policy decisions are much easier to institute and more responsive to economic conditions, but take longer to have an effect on spending in the economy.

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

Questions

  1. What are the Federal Reserve current observations and concerns?
  2. If the Federal Reserve is concerned as you outlined in the answer to question 1, what is it likely to do with its open market operations and the federal funds rate?
  3. How do changes in monetary policy affect spending in the economy?
  4. (More advanced) What are some "geopolitical risks" that could influence future economic conditions? How would economic conditions be affected?