Focus on Economic Data

RESOURCES

Reasons for a Case Study on the Federal Open Market Committee

Following Federal Open Market Committee announcements, newspapers across the country have front-page stories about Federal Reserve actions to change the target for interest rates and to either boost spending and employment in the U.S. economy or to slow growth in spending. The announcements reflect serious concerns with the state and direction of the economy and the resulting policy actions.

This case study is intended to guide students and teachers through an analysis of the actions the Federal Reserve is taking in an effort to reduce the amount of stimulus that it had been providing the economy. An understanding of monetary policy in action is fundamental to developing a thorough understanding of macroeconomics and the U.S. economy.

Notes 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. (Slides showing each paragraph of the excerpts of the announcement are included in the accompanying PowerPoint slides.)

• PowerPoint (23 KB)
• PDF (17 KB)

Announcement

The following is an excerpt from the January 31 announcement.

The Federal Open Market Committee decided today to raise its target for the federal funds rate by 25 basis points to 4-1/2 percent.

Although recent economic data have been uneven, the expansion in economic activity appears solid. Core inflation has stayed relatively low in recent months and longer-term inflation expectations remain contained. Nevertheless, possible increases in resource utilization as well as elevated energy prices have the potential to add to inflation pressures.

The Committee judges that some further policy firming may be needed to keep the risks to the attainment of both sustainable economic growth and price stability roughly in balance. In any event, the Committee will respond to changes in economic prospects as needed to foster these objectives.

The complete press release is available at:

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 March 27 and 28, 2006.) The seven Governors of the Federal Reserve Board and five of the twelve Presidents of the Federal Reserve Banks make up the committee. The staff of the Federal Reserve implements the recommended policies.

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 of the Federal Reserve, for four-year terms.

The seven Board members constitute a majority of the 12-member FOMC. The other five members of the FOMC are Reserve Bank presidents, one of whom is always the president of the Federal Reserve Bank of New York. The other Bank presidents serve one-year terms on a rotating basis. Traditionally, the Chairman of the Board of Governors serves as the Chairman of the FOMC.

Guide To Announcement

The Federal Open Market Committee has increased the target for its federal funds rate at each of its meetings since June 2004.

The first paragraph of the announcement summarizes the current monetary policy changes - this month it is the decision to increase the target federal funds rate for the fourteenth meeting in a row - increasing the target from 4.25 percent to 4.50 percent.

The language used to describe the increase assumes an understanding the definition of a basis point. There are 100 basis points in one percent of interest. Thus, an increase of 25 basis points is equal to one-quarter of one percent. The target for one interest rate - the federal funds rate - is being increased from 4.25 percent to 4.50 percent.

A brief summary of the reasoning behind the decision is presented in the second and third paragraphs,

In the second paragraph, reference is made to uneven recent data, meaning growth in real GDP that is less than desired, yet good data on employment and unemployment. The committee believes the economy continues to expand. The members are not currently concerned with inflationary pressure. However, the economy has faced higher energy prices and may be approaching a higher utilization of its capacity - both of which may increase inflationary pressures in the future.

In the third paragraph, the committee indicates that the risks are balanced between inflation ("price stability") and sustainable economic growth. This means that the chances of increased inflation and chances of a slowdown in the economic growth are about equal. However, in order to maintain that balance, the committee believes that it will need to continue its increases in the target federal funds rate in the future. The phrase "further policy firming" means that the FOMC will continue its increase in the target federal funds rate in order to remove the stimulate effects of the low rate in 2002, 2003, and 2004.

The final sentence in the third paragraph is added simply to reassure analysts that if expectations of inflation change or rates of increase in spending slow, the FOMC will change its policy quickly and change the target for the federal funds rate in an appropriate manner. If increased inflationary pressure appear, the FOMC is likely to increase the target federal funds rate more rapidly. If growth in spending in the economy were to slow, the FOMC would be likely to decrease the target.

There are also fourth and fifth paragraphs in a typical announcement. Those paragraphs will be discussed in the next case study.

Data Trends

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. See the figure showing changes in the target. (The periods of the 1990-1991 recession and the 2001 recession are shown in gray on the graph.)

Then as inflationary pressures began to increase in 1994, the Federal Reserve began to raise rates. In response to increased inflationary pressures once again in 1999, the Federal Reserve raised rates six times from June 1999 through May of 2000. Those changes are obvious in the graph.

Growth began to slow at the end of 2000. The slowing growth was one indication of the need for a change in monetary policy that would boost spending in the economy. The FOMC responded by cutting the target federal funds rate throughout the year.

Then as the economy began to recover from the recession and the FOMC turned to concerns that the economy did not need as much stimulation, a series of "measured" increases in the target were undertaken and are continuing with the current increase.

Tools of the Federal Reserve

The Federal Reserve buys and sells bonds and by doing so, increases or decreases banks' reserves and banks' abilities to make loans. As banks increase or decrease loans, the nation's money supply increases or decreases. That, in turn, decreases or increases interest rates. The purchase and sale of bonds by the Federal Reserve is called open market operations. The Federal Reserve is "operating," that is buying or selling, in the "open market" for U.S. Treasury securities.

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. The opposite occurs when the Federal Reserve buys a bond. The Federal Reserve gives a check to the seller of the bond. The seller deposits the check in their account. Their bank adds to the amount to the deposits and thus the money supply increases. The bank also presents the check back to the Federal Reserve, which in turn adds the amount to the bank's reserves. Because the bank has to keep only a portion of those reserves, the bank makes loans with the remainder. Thus the money supply expands even further. As banks attempt to make more loans, interest rates fall.

Open market operations are the primary tool of the Federal Reserve. It is a tool that is often used and is quite powerful. This is what the Federal Reserve actually does when it announces a new target for its 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 because the Federal Reserve has sold bonds, that interest rate is likely to increase. If the supply of reserves is increased because the Federal Reserve has purchased bonds, that interest rate is likely to decrease.

Banks earn profits by accepting deposits and lending part 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.

The Federal Reserve also has two other tools that may be used to influence the expansion of and contraction in the money supply and those will be introduced in the next FOMC case study.

How does Monetary Policy Work?

Monetary policy works by affecting the amount of money that is circulating in the economy, the level of interest rates, and changes in spending. 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 Reserve's check in her bank account. The bank's deposits and reserves increase. The bank then has an increased ability to make 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, machines, and tools, total spending increases. Consumer spending that partially depends upon levels of interest rates (automobile and appliances, for example) is also affected. Output and employment. In this case, unemployment will fall. There may also be some upward pressure on prices.

When the Federal Reserve adopts a restrictive monetary policy, it sells bonds in order to reduce the money supply. This results in higher interest rates and less spending. A restrictive monetary policy will decrease inflationary pressures, but it may also decrease investment spending and real gross domestic product. See the Inflation Case Study for a more detailed discussion of inflation.

Interactive Exercise

Questions

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

   [The Federal Reserve believes that the economy is growing without significant inflationary pressure. It goal is to remove the stimulative pressure created by low interest rates. It is implying that it will continue the gradual increases in the target federal funds rate, but is ready to change the direction of monetary policy if new conditions warrant.]

2. What tool will the Federal Reserve use to accomplish its goals?

   [The Federal Reserve can buy or sell U.S. Treasury bonds, which in turn will lower or increase the federal funds rate. To reduce the stimulative effects of recent policy, the FOMC is increasing the target for the federal funds rate. That means that the Federal Reserve is selling bonds. (Or it means that the Federal Reserve is slowing the growth of the money supply by purchasing fewer bonds than it otherwise would.)]

3. If the Federal Reserve were to become concerned about a slowing of the economic expansion, what is it likely to do with its open market operations and the federal funds rate?

   [The Federal Reserve would purchase more bonds to expand the money supply and bank reserves and that would lower the federal funds rate. The goal would be to increase overall spending in the economy.]

4. How do changes in monetary policy affect your family’s spending and business spending in the economy?

   [If the Federal Reserve is selling bonds, banks will have lower reserves due to decreased deposits. With the decreased reserves, they will have to decrease the number and size of loans. The decrease in loans and the resulting higher interest rates discourage business (and consumer) borrowing and spending. The decreased spending in the economy should result in decreased business production and employment.]