Explore the connection between the economic indicators and real-world issues. These lessons typically can be done in one class period.

KEY CONCEPTS

Discount Rate, Federal Reserve, Federal Reserve Structure, Fiscal Policy, Interest Rate, Monetary Policy, Open Market Operations, Reserve Requirements

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 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 indicates that output is continuing to expand at a solid rate and hiring appears to have picked up. Although incoming inflation data have moved somewhat higher, long-term inflation expectations appear to have remained well contained.

The Committee perceives the upside and downside risks to the attainment of sustainable growth for the next few quarters are roughly equal. Similarly, the risks to the goal of price stability have moved into balance. At this juncture, with inflation low and resource use slack, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured.

This complete press release is available at:

Reasons for a Case Study on the Federal Open Market Committee (FOMC)

Following most Federal Open Market Committee announcements, newspapers across the country have front-page stories about the Federal Reserve actions to change interest rates and increase (or reduce) spending and employment in the U.S. economy. Attention increased when growth in spending and output slowed in the economy in late 2000 and 2001. The economy entered a recession in March of 2001 and came out of the recession in November of that year. We then began to grow but without a rise in employment (in fact, employment continued to fall), and finally now when employment and real GDP are beginning to grow together.

The current announcement reflects confidence that economic conditions are improving and yet we are not growing so rapidly that we might cause a significant increase in inflation.

This case study is intended to guide students and teachers through an analysis of the recent and current actions of the Federal Reserve. An understanding of monetary policy in action is fundamental to developing a thorough understanding of macroeconomic policy, the U.S. economy, and financial markets.

[Note to Teachers: 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:

Guide To Announcement

The first paragraph of the announcement summarizes the current monetary policy changes - this month it is the decision to leave the target federal funds rate unchanged. The Federal Reserve Board of Governors also sets the discount rate, through a technical process of approving requests from the twelve Federal Reserve Banks. Although it is not mentioned in the announcement, the discount rate also was left unchanged at this meeting.

In the second and third paragraphs, the Federal Reserve discusses the reasoning behind the decision. The second paragraph refers to an “accommodative stance of monetary policy.” That means that the Federal Reserve is accommodating an increase in spending and economic growth with its current policy. The committee also believes that productivity continues to grow rapidly and allows the economy to expand without inflationary pressures.

New in this announcement is the statement that “hiring appears to have picked up.” The previous announcement stated, “although job losses have slowed, new hiring has lagged.” The last sentence is also new and indicates a somewhat increased emphasis on the possibility of increased inflationary expectations. The previous announcement said, “increases in core consumer prices are muted and expected to remain low.”

In the third paragraph “the Committee perceives the upside and downside risks to sustainable growth for the next few quarters are roughly equal.” This means that the current views of committee members are that spending and output are increasing at a rate that will result in neither an increase in unemployment nor an increase in spending that is too rapid. The second sentence is a slightly new emphasis on price stability. The previous announcement stated that the risk of deflation had lessened and at that point was almost equal to that of inflation. However, this now indicates that further progress has been made in regards to the possibility of deflation and the Federal Reserve is not as concerned as it was.

The final sentence also includes a slight revision. In March of this year, the announcement stated that the committee would be patient in changing its current policy. Now the committee is implying that it will eventually change its policy by raising its target federal funds rate, but that it will do so at a relatively slow pace.

[A fourth paragraph (not included above) 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. The decision to include voting details, which was implemented in 2002, is one step in a FOMC trend toward releasing more information immediately following the meetings. In this instance, all members of the FOMC voted to leave the target federal funds rate unchanged.]

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 4.5 percent and 3.7 percent in 1999 and 2000. During the first three quarters of 2001 (and the third quarter of 2000), real GDP actually decreased. For the year as a whole, real GDP increased only by .5 percent.

In response to the slowing economy, 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). That was the lowest target federal funds rate in forty years. At all 2002 meetings before one additional .5 percent cut at the November 2002 meeting, the FOMC decided to leave the federal funds rate unchanged.

During the fourth quarter of 2001, real GDP increased at an annual rate of 2 percent. In the first quarter of 2002, real GDP the annual rate of growth increased even more rapidly at a rate of 4.7 percent - evidence that the stimulative monetary policy was having an effect. For the entirety of 2002, real GDP increased by 2.2 percent. However, because the economy was not growing as rapidly as the Federal Reserve thought possible and because the committee was concerned about the possibility of deflation, the target federal funds rate was lowered in November of 2002 and then again in June of 2003. (For more on changes in the rate of growth of real GDP and the recession, see the most recent GDP Case Study.)

Figure 1: The Target Federal Funds Rate and the Discount Rate

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.

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 June 29 and 30. 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 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 that banks hold in reserves changes throughout the year and the Federal Reserve will buy or sell bonds to influence reserve levels and 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.

(Note: In January of 2003, the discount rate was changed to a level one-half of one percent above the target federal funds rate. The discount rate had normally been about one-half of a percent less than the target federal funds rate. Technical aspects of borrowing from the Fed were also changed at the same time. The basic functions of monetary policy were 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 .

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. (See the Unemployment Case Study for a more detailed discussion of employment and unemployment.)

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.)

A Problem

A news headline following the announcement:

“Stock Prices Fall as Investors Expect Interest Rate Change”

  1. Is the headline referring to an increase or a decrease in interest rates?

    [The Federal Reserve Open Market Committee changed its emphasis on current and future conditions slightly. Because the committee is somewhat more optimistic that the economy is growing and that the potential of deflation is no longer a problem, that might have led investors to expect that interest rates would increase sooner rather than later.]

  2. Why would that change in interest rates cause stock prices to fall?

    [An increase in interest rates will increase the opportunity cost of purchasing stocks and thus cause stock prices to fall. In addition, those increases may increase costs to businesses and thus decrease profits, again causing stock prices to fall.]

  3. Is there any other event that might lead one to think that the opposite might happen to stock prices?

    [The Federal Reserve is stating the conditions are improving and the economy is growing. That should result in higher expected profits and higher expected stock prices.]

Comparison of Monetary and Fiscal Policy

The FOMC was reacting to a slowing economy throughout 2001 and then once in 2002 and once in 2003. While the monetary policy was not been sufficient to prevent a recession, it surely has made the recession milder than it would have been otherwise and likely contributed to the recession ending sooner.

Fiscal policy, the taxing and spending policies of the federal government, has the potential to influence economic conditions. Throughout 2003, there were debates in Congress about what to do with spending and taxes in order to stimulate spending. Taxes were lowered and spending increased. This points to one of the key differences between fiscal and monetary policy. Fiscal policy is much more difficult to implement. However, fiscal policy, once adopted, will be likely to have a faster effect on spending. Monetary policy decisions are much easier to institute and more responsive to economic conditions, but take longer to actually have an 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. ( )

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 begin to change their spending and government to change spending). The combined lags may be anywhere from one to almost five years.

Questions

  1. What are the Federal Reserve current observations and concerns?

    [While the Federal Reserve is optimistic about future conditions and believes that employment is rising, it is aware that inflationary pressures may develop. They expect that they will slow the growth in the money supply in the future and create higher interest rates.]

  2. What tools can the Federal Reserve use?

    [The Federal Reserve can buy or sell bonds, which in turn will lower or increase the federal funds rate. The Federal Reserve can also change reserve requirements and the discount rate.]

  3. If the Federal Reserve is concerned about the potential of inflation, what is it likely to do with its open market operations and the federal funds rate?

    [The Federal Reserve would sell bonds to decrease the money supply and reserves and increase the target federal funds rate.]

  4. If the Federal Reserve is concerned about potentially increased inflationary pressures and decided to use changes in reserve requirement and the discount rate, what would it do?

    [The Federal Reserve would raise reserve requirements and increase the discount rate.]

  5. 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 Fed will buy bonds and the resulting increased availability of loans and lower interest rates may encourage businesses and consumers to increase their spending.]