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 September 20 announcement.

The Federal Open Market Committee decided today to keep its target for the federal funds rate at 5-1/4 percent.

The moderation in economic growth appears to be continuing, partly reflecting a cooling of the housing market.

Readings on core inflation have been elevated, and the high levels of resource utilization and of the prices of energy and other commodities have the potential to sustain inflation pressures. However, inflation pressures seem likely to moderate over time, reflecting reduced impetus from energy prices, contained inflation expectations, and the cumulative effects of monetary policy actions and other factors restraining aggregate demand.

Nonetheless, 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.

The complete press release is available at: [EEL-link id='1827' title='www.federalreserve.gov/' ]

Guide To Announcement

The first paragraph of the announcement summarizes the current monetary policy changes or the continuation of an existing policy - this month it is the decision to not change the target federal funds rate. This is the second consecutive month that it has kept the target at the 5.25 percent level established in June, 2006.

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

In the second paragraph, reference is made to the slowing in economic growth continuing and the importance of the housing market to that slower growth. Prices housing are not rising as rapidly as in the recent past and falling in some parts of the country. This paragraph is similar to the same paragraph in the August announcement. The August announcement did refer to lagged effects of increased interest rates and higher energy prices as partially responsible for the slowing economy.

The third paragraph is almost identical to the third paragraph in the previous announcement. Reference is made to increased core inflation rates. (See the most recent inflation case study.) Core inflation is the rate of inflation excluding energy and food prices and is meant to indicate trends and expectations of further inflation. Further increases in energy prices may continue to contribute to inflation across the economy. The economy is using much of its capacity and increased use will create additional inflationary pressures. In spite of these concerns the final sentence states that the committee believes inflationary pressures will become less as increases in energy prices disappear and even fall, as inflationary expectations on the part of business and workers are reduced, and as past tightening in monetary policy has its effects on the economy.

The fourth paragraph is identical to the previous announcement. The committee is concerned about the continuing risk of inflation. The additional firming means that the committee will increase the target federal funds rate if forecasts of increased inflation change. In addition, new information will affect its discussions and decisions.

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

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 October 24 and 25, 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.)

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 continued through June of this year.

The Federal Open Market Committee increased the target for its federal funds rate at each of its meetings from June 2004 to June 2006. The seventeen consecutive increases of ¼ of one percent raised the target for the federal funds rate from 1 percent to 5.25 percent.

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 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.

Interactive Questions

Click the start button below for an online interactive activity.

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