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 with a goal of either boosting spending and employment in the U.S. economy or slowing growth in spending and employment. The announcements often reflect serious concerns with the state and direction of the economy and recommend appropriate 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.

Announcement

The following is the June 29 announcement.

The Federal Open Market Committee decided today to raise its target for the federal funds rate by 25 basis points to 5-1/4 percent.

Recent indicators suggest that economic growth is moderating from its quite strong pace earlier this year, partly reflecting a gradual cooling of the housing market and the lagged effects of increases in interest rates and energy prices.

Readings on core inflation have been elevated in recent months. Ongoing productivity gains have held down the rise in unit labor costs, and inflation expectations remain contained. However, the high levels of resource utilization and of the prices of energy and other commodities have the potential to sustain inflation pressures.

Although the moderation in the growth of aggregate demand should help to limit inflation pressures over time, the Committee judges that some inflation risks remain. The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information. In any event, the Committee will respond to changes in economic prospects as needed to support the attainment of its objectives.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Susan S. Bies; Jack Guynn; Donald L. Kohn; Randall S. Kroszner; Jeffrey M. Lacker; Sandra Pianalto; Kevin M. Warsh; and Janet L. Yellen.

In a related action, the Board of Governors unanimously approved a 25-basis-point increase in the discount rate to 6-1/4 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, and Dallas.

The complete press release is available at: [EEL-link id='1299' title='www.federalreserve.gov/boarddocs/press/monetary/2006/20060629/' ]

Interactive Exercise

Click here for an online interactive activity.

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. This is the seventeenth meeting in a row at which the target for the federal funds rate has been increased by .25 percent. The first paragraph and the last two paragraphs have become standard in recent announcements. The second, third, and fourth are the most meaningful in understanding FOMC thinking about current and future economic conditions.

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 - increasing the target from 5 percent to 5.25 percent. The paragraph is identical to the previous announcement, with the exception of the level of the interest rate. 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 5 percent to 5.25 percent.

A brief summary of the reasoning behind the decision is presented in the second and third paragraphs. In May, the Committee forecast that growth would moderate. Here the Committee is saying that it has moderated. The causes are identical to those stated in the May announcement ---partly reflecting a gradual cooling of the housing market and the lagged effects of increases in interest rates and energy prices.

The third paragraph is similar to the description in the May announcement However, this month's statement on inflation is a bit stronger than the statement in May and certainly points to the Committee's concern along with a recognition that inflationary pressures exist.

The fourth paragraph has changed a bit. Last month, the Committee stated that further firming may be needed. The "further firming" means an increase in interest rates. This month's announcement is slightly more open to questioning whether further increases will be needed. The implication is that it may well be that the moderation in growth and the effects of recent changes in monetary policy will be sufficient to reduce inflationary pressures.

The final sentence in the fourth paragraph is added simply to reassure analysts that if expectations of inflation or rates of increase in spending change , the FOMC will change its policy quickly and change the target for the federal funds rate in an appropriate manner. (The sentence is identical to the last sentence of the fourth paragraph in the previous announcement.) 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.

The next to the last paragraph reports the vote of the Committee on the policy recommendation. The vote is most often a unanimous one following a thorough discussion and debate of the issues.

The Federal Reserve Board of Governors actually sets an interest rate known as the discount rate. This is the focus of the final paragraph. The technical process is one of approving requests for a change received from the twelve Federal Reserve Banks. In this announcement, the discount rate is increased by ¼ of one percent to a level of 6.25 percent. More discussion of the discount rate follows below.

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 8, 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.

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 figure 1 showing changes in the target. (The periods of the 1990-1991 recession and the 2001 recession are shown in gray on the figures.)

Graph 1

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 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 Discount Rate

The discount rate is the interest rate the Federal Reserve charges banks if banks borrow reserves from the Federal Reserve itself. Banks may need to borrow reserves if they have made too many loans, have experienced withdrawals of deposits or currency, or have had fewer deposits than they expected.

In reality, banks seldom borrow reserves from the Federal Reserve and tend to rely more on borrowing reserves from other banks when they are needed. They will still pay an interest rate (the federal funds rate), but that is a rate determined in the market for reserves and influenced by the open market operations of the Federal Reserve.

The discount rate is most often changed along with the target for the federal funds rate, but the discount rate change does not have a very important effect as so few banks actually use that means of borrowing reserves. In this announcement, the discount rate is increased along with the federal funds rate.

Figure 2 shows the discount rate along with the federal funds rate. Notice that the discount rate typically changes along with the target for the federal funds rate. Prior to 2003, the discount rate was below the target federal funds rate. Since then the discount rate has been one percent above the target federal funds rate. That is an additional reason that there is little current borrowing of reserves directly from the Federal Reserve.

Graph 2

Reserve Requirements

Banks are required by law to hold a portion of some of their deposits in what are called reserves. The portion varies depending upon the type of deposits and the size of the bank. Most are required to have either 3 or 10 percent of their deposits on reserve. Reserves consist of the amount of currency that a bank holds in its vaults and the bank's deposits at Federal Reserve banks. These are portions of a bank's deposits that cannot be loaned to other customers.

If banks have more reserves than they are required to have, they can increase their lending. If they have insufficient reserves, that is, less than they are required to have, they have to curtail their lending or borrow reserves from the Federal Reserve or from another bank. If another bank has more reserves than they are required to maintain, those extra reserves are called excess reserves. The reserve requirement is seldom changed, but it has a potentially very large effect on the ability to make loans and thus on interest rates.

If the Federal Reserve were to increase the reserve requirements, banks would have to curtail loans and the money supply would shrink. If the reserve requirements were lowered, banks would have excess reserves and they could increase the amount and number of loans they make.

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 will likely increase as spending increases. 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 cause real gross domestic product to decrease or to increase more slowly. See the Inflation Case Study for a more detailed discussion of inflation.

The Committee actually instructs the Federal Reserve Bank of New York to execute transactions in what is called the System Account in accordance with a domestic policy directive. The most recent directive was most likely something like the following: The Federal Open Market Committee seeks monetary and financial conditions that will foster price stability and promote sustainable growth in output. To further its long-run objectives, the Committee in the immediate future seeks conditions in reserve markets consistent with increasing the federal funds rate to an average of around 5.25 percent." This means that the Federal Reserve Bank of New York is to buy and sell U.S. Treasury bonds so that the changes in bank reserves result in a federal funds rate of 5.25 percent.

Full employment real GDP

Economists define the approximate unemployment rate, at which there are not upward or downward pressures on wages and prices, as the full employment rate of unemployment. If unemployment falls to level below the full employment rate, there will be upward pressure on wages and prices. In fact, that is the definition of the full employment rate.

If unemployment rises to a rate that is higher than the full employment rate of unemployment, there will downward pressure on wages and prices. In the middle is a level, or more likely a range, where there is no pressure on wages and prices to rise or fall.

The level of real GDP that can be produced at that rate of unemployment is described at the full employment level of real GDP. Sometimes it is described as the potential level of real GDP. It is the highest level that an economy can produce at any given time without causing significant inflation.

The challenge for the Federal Reserve is to be able to forecast what the future level of full employment real GDP will be and then to forecast what the actual level of real GDP will be at that time. The FOMC has to forecast, not simply determine what those levels are now, because its monetary policy takes time to work. So if the FOMC believes that real GDP will be above the full employment level nine months or a year from now, it will reduce the money supply. If it believes that the future level of real GDP will be below the full employment level, it will expand the money supply.

Interactive Questions

Comparison of the Current Announcement with the Previous Announcement

The FOMC reacts to a slowing economy by expanding the money supply, lowering interest rates, and creating increased spending. The reaction to increasing inflationary pressures is to decrease the money supply, raise interest rates, and thereby slowing growth in spending.

Fiscal policy is the taxing and spending policies of the federal government. Those policies also have the potential to influence economic conditions whether deliberately or as an unintended consequence. If the economy is entering a recession, fiscal policy response might be to increase government spending and to lower taxes. If spending in the economy is growing too rapidly, the fiscal response might be to decrease government spending and to increase taxes.

In those processes, there will be debates in Congress about what to do with spending and taxes in order to stimulate or slow overall spending in the economy. These debates normally take a substantial amount of time. This lag points to one of the key differences between fiscal and monetary policy. Fiscal policy is much more difficult to implement but once the decision is made, it takes effect quickly. Monetary policy decisions are much easier to institute and more responsive to economic conditions, but actually take longer to change spending once the decision is made.

Questions

  1. What are the Federal Reserve current observations and concerns?
  2. What tool will the Federal Reserve use to accomplish its goals?
  3. If the Federal Reserve is expanding the money supply due to overall growth in the economy and the rising need for money to carry on business, what will the Federal Reserve do if it becomes concerned by increasing inflationary pressures? (This is a more difficult question. Think carefully here.)
  4. 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?
  5. How do changes in monetary policy affect your family's spending and business spending in the economy?