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Announcement

The Federal Reserve announced today that there would be no change in monetary policy.

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

Following recent Federal Reserve policy announcements, newspapers across the country have had front-page stories about the Federal Reserve actions to target interest rates and boost spending and employment in the U.S. economy. Attention increased as the economy during the recession that began in March of 2001 and ended in November of 2001. Real GDP actually fell in the first three quarters of 2001 and has increased only gradually since. Employment has fallen since. Unemployment has steadily increased since March of 2001. The announcements since have reflected 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 takes in efforts to achieve price stability and economic growth. An understanding of monetary policy in action is fundamental to developing a thorough understanding of macroeconomics and the U.S. economy.

[Note to teacher: The material in this case study in italics is not included in the student version. This initial case study of the semester introduces relevant concepts and issues. Subsequent case studies following FOMC announcements will describe the announcement and add concepts and complexity throughout the semester.

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

• PowerPoint (53 KB)
• PDF (17 KB)]

Guide To Announcement

“The Federal Open Market Committee decided today to keep its target for the federal funds rate at 1 percent.

“The Committee continues to believe that an accommodative stance of monetary policy, coupled with robust underlying growth in productivity, is providing important ongoing support to economic activity. The evidence accumulated over the intermeeting period confirms that spending is firming, although the labor market has been weakening. Business pricing power and increases in core consumer prices remain muted.

“The Committee perceives that the upside and downside risks to the attainment of sustainable growth for the next few quarters are roughly equal. In contrast, the probability, though minor, of an unwelcome fall in inflation exceeds that of a rise in inflation from its already low level. The Committee judges that, on balance, the risk of inflation becoming undesirably low remains the predominant concern for the foreseeable future. In these circumstances, the Committee believes that policy accommodation can be maintained for a considerable period.”

“Voting for the FOMC monetary policy action were: Alan Greenspan, Chairman; Ben S. Bernanke; Susan S. Bies; J. Alfred Broaddus, Jr.; Roger W. Ferguson, Jr.; Edward M. Gramlich; Jack Guynn; Donald L. Kohn; Michael H. Moskow; Mark W. Olson; Robert T. Parry; and Jamie B. Stewart, Jr.”

This press release is available at: www.federalreserve.gov/boardcocs/press/monetary/2003/20030916/

The first paragraph of this announcement summarizes the current monetary policy changes - this month it is the decision to leave the target federal funds rate at 1 percent. This is the lowest target federal funds rate in forty-five years. This means that the Federal Reserve will continue its current open market operations (the buying and selling of bonds) in such a manner that short-term interest rates do not change.

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 is not mentioned in the announcement. That indicates that there were no changes. It is unlikely that the discount rate would be changed without changes in the target federal funds rate.

In the second paragraph, the FOMC discusses the current economic situation and the reasoning behind their decisions. It is stated “the accommodative stance of monetary policy, coupled with robust underlying growth in productivity, is providing important ongoing support to economic activity.” The accommodative stance refers to low interest rates and an expanding money supply to encourage increased spending and production in the economy. The reference to growth in productivity refers to the rather rapid recent increases in productivity. (See the most recent Productivity case.)

The statement that spending is firming actually refers to the fact that spending is beginning to increase more rapidly. However, the Federal Reserve remains concerned with high unemployment and the lack of growth in employment. Inflation is not a current problem.

The third paragraph begins by stating that the FOMC perceives the risks of spending growing at a slower or faster rate than the potential output of the economy are balanced. That is, at the present time, it is not concerned with too much or too little growth in spending. That is the explanation of the statement about upside and downside risks.

The FOMC is concerned with the possibility of falls in inflation, more than it is with increases in the rate of inflation. While the committee is stating that the probability is “minor”, this statement means that it does want to prevent and is concerned with the possibility of deflationary conditions (that is, falling prices).

The fourth paragraph describes the votes of the FOMC members on current monetary policy. All members of the FOMC voted in favor of the current policy.

Data Trends

The FOMC engaged in an active monetary policy 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. (The 1990-1991 and 2001 recessions are indicated by the gray banners on the federal funds rate graph.)

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 FOMC raised rates six times from June 1999 through May of 2000. Throughout the 1990s, the FOMC changed the target federal funds rate in all but one year. In three of those years however, the rate was changed only a single time.

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 2001 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.

During 2002, real GDP growth rebounded slightly as real GDP increased 2.4 percent. In the first quarter of 2003, the annual rate of growth was slightly less, 1.4 percent, but increased in the second quarter of 2003 to 3.1 percent. Growth in real GDP is expected to increase even more rapidly in the third and fourth quarters of this year.

While stimulative monetary policy surely had a positive effect on real GDP, the growth has not been fast enough to match the increased potential real GDP and to keep unemployment low. (For more on changes in the rate of growth of real GDP and the current recession, see the most recent GDP Case Study.)

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. On November 6, 2002, the Federal Reserve Open market committee lowered the target federal funds rate by an additional .5 percent to 1.25 percent. At all 2002 meetings before the cut at the November meeting, the FOMC decided to leave the federal funds rate unchanged. The federal funds rate was again lowered, this time to 1.00 percent, in June of 2003.

As of the current announcement, the Federal Reserve is clearly still concerned with falling employment and rising unemployment.

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. The recession officially ended in November of 2001.

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 data showed a decline in employment. Unemployment has also increased. Real income growth slowed but did not decline. Manufacturing and trade sales and industrial production have both declined and are only now beginning to turn around.

While the common media definition of a recession is two consecutive quarters of decline in real GDP, this recession was announced as beginning 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.

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

Deflation

Deflation is the opposite of inflation. We experience deflation if prices across the economy, that is if most prices, are falling. This announcement refers to the possibility of “an unwelcome substantial fall in inflation.” As recent inflation has been quite low, the FOMC announcement points to concerns that inflation might turn into a deflation.

Why should we be concerned with falling prices? It sounds good. The concern is that if prices throughout the economy are falling, consumers and businesses may reduce spending because they expect even lower prices in the near future. That would put further downward pressure on spending, production, and employment. In addition, businesses and individual debtors may face increased pressures. As sales (and incomes) and therefore profits fall in nominal terms, the amount of debt does not change. Instead it becomes an ever-increasing percentage of income and makes it more difficult to make timely payments.

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 August 12.) 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.

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 target federal funds rate, but the change does not have a very important effect. In this announcement, the discount rate is not mentioned and was not changed.

[Prior to January of 2003, the discount rate was most often about a half of a percentage point below the target federal funds rate. Banks were discouraged through regulations from borrowing from the Federal Reserve and encouraged to borrow reserves from other banks. The discount rate is now one percent above the target federal funds rate and banks are no longer discouraged from borrowing if they wish to pay the higher rate for reserves. (Notice in the graph that the discount rate jumps above the target federal funds rate at the beginning of 2003.)]

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 and has not been for more than a decade.

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 recession and the slowing recovering economy over the past two and one-half years. While the monetary policy was not been sufficient to prevent a recession, it surely made the recession milder and likely contributed to the recession ending sooner than it would have otherwise.

Fiscal policy, the taxing and spending policies of the federal government, has the potential to influence economic conditions. Taxes have recently been decreased in order to reduce tax burdens and in efforts to encourage businesses and individuals to increase spending. Throughout the last three years, there have been lengthy debates in Congress about what to do with spending and taxes in order to stimulate spending. This lengthy debate points to one of the key differences between fiscal and monetary policy. Fiscal policy is much more difficult to implement but takes effect quicker. Monetary policy decisions are much easier to institute and more responsive to economic conditions, but take longer to take effect.

Creation of the Federal Open Market Committee

The seven members of the Board of Governors are appointed by the President and confirmed by the Senate to serve 14-year terms of office. Members may serve only one full term, but a member who has been appointed to complete an unexpired term may be reappointed to a full term. The President designates, and the Senate confirms, two members of the Board to be Chairman and Vice Chairman, for four-year terms.

Only one member of the Board may be selected from any one of the twelve Federal Reserve Districts. In making appointments, the President is directed by law to select a "fair representation of the financial, agricultural, industrial, and commercial interests and geographical divisions of the country." These aspects of selection are intended to ensure representation of regional interests and the interests of various sectors of the public.

The seven Board members constitute a majority of the 12-member Federal Open Market Committee (FOMC), the group that makes the key decisions affecting the cost and availability of money and credit in the economy. The other five members of the FOMC are Reserve Bank presidents, one of whom is the president of the Federal Reserve Bank of New York. The other Bank presidents serve one-year terms on a rotating basis. By statute the FOMC determines its own organization, and by tradition it elects the Chairman of the Board of Governors as its Chairman and the President of the New York Bank as its Vice Chairman.

(www.federalreserve.gov/pubs/frseries/frseri.htm )

Questions

1. What are the Federal Reserve current observations and concerns?
   
   [While the Federal Reserve is optimistic about growing productivity and rising spending, committee members are still concerned with high unemployment, falling employment, and the small possibility of falling prices.]
2. How do changes in monetary policy affect spending in the economy?
   
   [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. 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.]