INTRODUCTION

The Federal Open Market Committee of the Federal Reserve System meets approximately every six weeks to determine the nation's monetary policy goals and, specifically, set the target for the federal funds rate (Fed Funds Rate). The Fed Funds Rate is the interest rate at which banks lend balances at the Federal Reserve to other banks, usually overnight.

This lesson focuses on the October 29, 2008, announcement by the Federal Open Market Committee on the current Federal Reserve monetary policy actions and goals.

Key U.S. Economic Indicators as of October 30, 2008

Inflation: The Consumer Price Index for All Urban Consumers (CPI-U) decreased 0.1 percent in September, before seasonal adjustment. The September level of 218.783 was 4.9 percent higher than in September 2007. (October 16, 2008)

Unemployment: U.S. nonfarm payroll employment declined by 159,000 in September, and the unemployment rate held at 6.1 percent, (October 3, 2008)

Real GDP Growth: U.S. real gross domestic product decreased at an annual rate of 0.3 percent in the third quarter of 2008,(advance estimate). In the second quarter, real GDP increased 2.8 percent.  (October 30, 2008)

Federal Reserve Policy: At its October 29 meeting, the Federal Open Market Committee decided to reduce the target for the federal funds rate by 1/2 percent (50 basis points) to 1.0 percent. (October 29, 2008)

TASK

  • Identify the current FOMC goals and policy actions.
  • Define the Federal Funds rate and how it is used as a monetary policy tool.
  • Determine the intended impact of the policy actions on price stability, economic growth, and employment.
  • Determine how monetary policy actions impact the ability of banks to make loans, and consumers and businesses to borrow funds.

PROCESS

The FOMC announcement, October 29, 2008:

"The Federal Open Market Committee decided today to lower its target for the federal funds rate 50 basis points to 1 percent."

The October 29 vote of the FOMC members was unanimous.

Monetary Policy Goals

Since the passage of The Employment Act of 1946 (U.S. Code Title 15 Section 1021), it has been the mandate of the federal government to "create and maintain useful employment, with fair compensation for the people employed, and to promote maximum employment, production, and purchasing power." This legislation has evolved into the current system of using fiscal and monetary policies to stabilize the economy and promote growth.

As a requirement of the Employment Act of 1946, the Chairman of the Federal Reserve Board regularly testifies before Congress on the state of the economy and Federal Reserve policies. This testimony draws considerable press attention, as do many public statements by Fed board members. The press, businesses, and many in the public look for information about the direction of Fed policies between regular FOMC announcements.

In December 2003, when former Federal Reserve Chairman Allan Greenspan characterized stock market investors as 'irrationally exuberant,' it was widely interpreted as a negative comment about the stability of economy.

Monetary policy is based on the assumption that the level of economic activity and the health of an economy can be impacted by changes in the money supply. Money supply changes influence credit creation and the overall level of economic activity.

Economists constantly debate importance to the measurements of the money supply. M1 is the currency in circulation and in easily accessible deposit accounts. More broad measurements such as M2 and M3 include less liquid money supply, such as term deposits and money market mutual funds.

The debate extends from the appropriateness of central bank intervention in the economy to its effectiveness, considering the lengthy time lags inherent in the monetary policy process. History has shown that such intervention has been effective in times of extreme inflation and recession. The question is always one of timing - when and how much intervention is necessary. In a global economy, can the Federal Reserve effectively implement monetary policy to achieve its domestic stabilization and growth goals?

A 2005 report on "The Effectiveness of Monetary Policy," by Robert H. Rasche and Marcela M. Williams from the Federal Reserve Bank of St. Louis, sums up the debate. 'The case for consistently effective short-run monetary stabilization policies is problematic – there are just too many dimensions to uncertainty in the environment in which central banks operate."

Click on this link for the full Federal Reserve Bank of St. Louis report, The Effectiveness of Monetary Policy .

The Fed Funds Rate Rollercoaster

Over the past eighteen years, a graph of the fed funds rate looks like a rollercoaster – a series of ups and downs – as the FOMC has changed the rate to expand and contract the money supply in response to changing economic conditions.

In the 1980s, the FOMC began targeting a specific level for the federal funds rate. Beginning in 1994, the FOMC began announcing its policy goals, explicitly stating the target level.

In July 1990, the fed funds rate was historically high at 8.0 percent. Over two years, seventeen 25 basis point decreases brought it down 500 basis points to 3.0 percent. In February 1994, the FOMC began increasing the rate quickly over a year to 6.0 percent in February 1995. Reversing course in July 2005 the FOMC began six years of small increases and decreases that kept the rate between 4.75 and 6.0 percent. Then, a series of 25-50 basis point decreases from January 2001 to June 2003 brought the rate steadily down.

The last time the fed funds rate was as low as 1.0 percent was in June 2003. Over the next three years, seventeen straight increases of 25 basis points brought the rate to a high of 5.25 percent in June 2006. Beginning in September 2006, nine straight rate increases, six of them being 50 or 75 basis points, have brought the rate back down to the current 1.0 percent.

Figure 1 illustrates the recent history of federal funds rate changes.

Federal Reserve Figure 1

Since February 2000, the FOMC’s announcements have included an assessment of the risks to the achieving the long-run goals of price stability, full employment and economic growth. The October 30 announcement expressly stated the committees concerns about the economic downturn and crisis in financial markets.

The FOMC explanation for the October 29, 2008, monetary policy action to reduce the target for the federal funds rate:

As stated in the announcement, the FOMC members had these concerns:

Consumer and business spending - "The pace of economic activity appears to have slowed markedly, owing importantly to a decline in consumer expenditures. Business equipment spending and industrial production have weakened in recent months, and slowing economic activity in many foreign economies is damping the prospects for U.S. exports."

Continued Problems in Financial Markets - "Intensification of financial market turmoil is likely to exert additional restraint on spending, partly by further reducing the ability of households and businesses to obtain credit. In light of the declines in the prices of energy and other commodities and the weaker prospects for economic activity, the Committee expects inflation to moderate in coming quarters to levels consistent with price stability."

Their rationale was - "Recent policy actions, including today’s rate reduction, coordinated interest rate cuts by central banks, extraordinary liquidity measures, and official steps to strengthen financial systems, should help over time to improve credit conditions and promote a return to moderate economic growth. Nevertheless, downside risks to growth remain.

The FOMC continues to be cautious - "The Committee will monitor economic and financial developments carefully and will act as needed to promote sustainable economic growth and price stability."

Clearly, the FOMC is concerned that the U.S. (and possibly the world) is entering or has been in a significant downturn or recession. The Bureau of Economic Analysis (BEA) announcement of real growth of U.S. gross domestic product on October 30 reinforced the FOMC's concern. The BEA's advance estimate of real GDP for the third quarter of 2008 was a 0.3 percent decrease.

Does the October 29 announcement reflect that the FOMC thinks the U.S. is in a recession? The direction of the fed funds rate target seems to indicate so. What do you think?

More information: A Brief Overview of the FOMC and Monetary Policy

What is the Federal Open Market Committee and how does it operate?

The Federal Open Market Committee (FOMC) of the Federal Reserve System (Fed) meets eight times annually, approximately every six weeks, to review economic and financial conditions, assess the risks to the nations' long-run goals of price stability, full employment, and sustainable economic growth, and determine the appropriate stance of monetary policy.

The Federal Reserve influences the demand for and supply of the balances that depository institutions hold at Federal Reserve Banks and in this way alters the federal funds rate. The federal funds rate is the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight.

Click on this link for more information on the Federal Open Market Committee and its process.

The Federal Reserve has three primary tools to use to implement monetary policy.

Open Market Operations

The Federal Reserve buys and sells government securities 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 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" by buying or selling securities in the "open market."

Click on this link For more information about Open Market Operations .

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. Banks can borrow reserves from the Federal Reserve or from other banks.

Click on this link for more information about The Discount Rate .

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, depending on the size of the accounts. Reserves consist of the amount of currency that a bank holds in its vault and the bank's deposits at Federal Reserve banks. The required reserve is the portion of a bank's deposits that cannot be loaned to other customers.

Click on this link for more information about Reserve Requirements .

In addition, the Federal Reserve System has developed programs to provide greater liquidity to the banking system and to provide additional security to financial markets. They are:

  • Term Auction Facility
  • Primary Dealer Credit Facility
  • Term Securities Lending Facility
  • ABCP MMMF Liquidity Facility
  • Commercial Paper Funding Facility
  • Money Market Investor Funding Facility

For more information about these Federal Reserve monetary policy programs, visit the Federal Open Market Committee [4] page. Click on the links to the individual program descriptions.

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.

Click on this link for more information on Monetary Policy .

What works best - monetary policy or fiscal policy?

The FOMC uses monetary policies to react to a slowing economy by expanding the money supply, lowering interest rates, thus encouraging increased spending. The FOMC reaction to increasing inflationary pressures is to decrease the money supply, raise interest rates, and thereby slowing growth in spending.

Another set of policy options, 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 of changes in taxes and spending adopted for reasons other than to influence economic conditions. 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.

Click on this link for more information about U.S. Fiscal Policies .

CONCLUSION

Summary:

On October 29, the FOMC reduced the target for the federal funds rate to 1.0 percent, matching its lowest levels since the 1990s. In the announcement, the FOMC expressed concern that the economy's troubles are far from over.

Worsening conditions in the U.S. economy and financial markets may cause the Federal Reserve to take additional actions soon or wait until its next scheduled meeting on December 16, 2008. The Fed is a primary player in the development of plans to "bailout" weakening financial markets. New Fed programs, such as the "Term Auction Facility" and the "Money Market Investor Funding Facility" have been designed to provide financial market liquidity and security.

A St. Louis Federal Reserve Bank report on the "Effective Federal Funds Rate" indicates that the actual rate has been below 1 percent since early October. The "effective" or "actual" rate is the rate at which the overnight loans are actually made between banks. It seems like the FOMC action in October is simply recognizing what is actually taking place in the market.

Targeting the fed funds rate continues to be the primary monetary policy action during these uncertain times, but may not be enough to provide the stimulus necessary to stabilize the economy. The Fed, the U.S. Treasury and Congress have cooperated to use both monetary and fiscal policies to stimulate growth.

[NOTE: This focus on economic data is being written just prior to the November 4 elections. The outcome of the election may determine which Treasury or legislative actions are used in conjunction with Fed policies. The election will not immediately impact the Fed, but can if a new president appoints new members to the Federal Reserve Board of Governors. The new president will appoint at least two board members in the next four years, including the chairman.]

ASSESSMENT ACTIVITY

Respond to these writing prompts by completing the interactive notepad below.

 

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

  2. If the FOMC decides to stimulate the economy, what tool will the Federal Reserve most likely use to accomplish its goals?

  3. The Federal Reserve uses monetary policy tools to stimulate or contract the level of economic activity. Recently, the federal government has used fiscal policies to stimulate growth. Congress voted to rebate tax revenues to U.S. tax payers. How was this strategy designed to work?

  4. Given that the effective fed funds rate (the rate actually used in the market) has been consistently below the FOMC's target rate, what difference does it make when the fed announces a lower rate target?

EXTENSION ACTIVITY

The World Interest Rates Table tracks interest rates in 23 countries around the world.

Notice that the central bank rates of most of the nations are higher - some much higher - than the U.S. rates. You can examine the rates in the several world regions to speculate about how they relate to inflation and growth in those regions. You can investigate the current economic conditions in the regions and how they compare and relate to currrent conditions in the U.S.