INTRODUCTION

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

This lesson focuses on the January 28, 2009, announcement by the Federal Open Market Committee on the current Federal Reserve monetary policy actions and goals. It also include an introduction to the structure and functions of the Federal Reserve.

TASK

  • Explain the structure and functions of the U.S. Federal Reserve System and the Federal Open Market Committee.
  • Identify and explain the monetary policy tools of the Federal Reserve System.
  • Identify the current FOMC policy goals and 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.

PROCESS

Federal Open Market Committee Press Release:  January 28, 2009

"The Federal Open Market Committee decided today to keep its target range for the federal funds rate at 0 to 1/4 percent. The Committee continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time."

The FOMC decided to keep the fed funds target rate at the level set in December, 2008, primarily because further reducing the target rate to zero would be not have any real effect, given the current target and that the real market fed funds rate is near zero. Without further lowering of the fed funds rate as a tool to increase bank reserves and stimulate growth, the Federal Reserve must use other, non-traditional tools to implement its policy goals.

This unusually detailed announcement commented on the reasons for the FOMC action and the concerns of the committee.

"Information received since the Committee met in December suggests that the economy has weakened further. Industrial production, housing starts, and employment have continued to decline steeply, as consumers and businesses have cut back spending. Furthermore, global demand appears to be slowing significantly. Conditions in some financial markets have improved, in part reflecting government efforts to provide liquidity and strengthen financial institutions; nevertheless, credit conditions for households and firms remain extremely tight. The Committee anticipates that a gradual recovery in economic activity will begin later this year, but the downside risks to that outlook are significant."

Although the target fed funds rate was kept the same, the FOMC sent a strong message that it was not going to just wait and see, citing further evidence of economic slowdown, only a hint of recovery of financial markets, and "downside risks."

The FOMC announcement commented on the prospects for inflation.

"In light of the declines in the prices of energy and other commodities in recent months and the prospects for considerable economic slack, the Committee expects that inflation pressures will remain subdued in coming quarters. Moreover, the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term.

Price stability has long been "enemy number one" of the FOMC. Several times in recent years, rates have been raised to prevent inflation at the expense of economic growth. The traditional trade-off between stimulating growth and price stability is no longer a key issue.

The FOMC announcement suggested how the committee will continue to assess economic conditions and consider further actions.

"The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. The focus of the Committee's policy is to support the functioning of financial markets and stimulate the economy through open market operations and other measures that are likely to keep the size of the Federal Reserve's balance sheet at a high level. The Federal Reserve continues to purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand the quantity of such purchases and the duration of the purchase program as conditions warrant."

"The Committee also is prepared to purchase longer-term Treasury securities if evolving circumstances indicate that such transactions would be particularly effective in improving conditions in private credit markets. The Federal Reserve will be implementing the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses. The Committee will continue to monitor carefully the size and composition of the Federal Reserve's balance sheet in light of evolving financial market developments and to assess whether expansions of or modifications to lending facilities would serve to further support credit markets and economic activity and help to preserve price stability."

The FOMC was very specific about the use of new tools to increase financial market liquidity and lending, and made it clear that more radical actions would be used if warranted. This specificity in an FOMC announcement is very unusual, but the current economic conditions may require unusual actions.

This FOMC statement was not accepted unanimously by the committee members. Jeffrey M. Lacker, President of the Federal Reserve Bank of Richmond votes against the action, preferring to "expand the monetary base at this time by purchasing U.S. Treasury securities rather than through targeted credit programs."

Mr. Lacker's "no" vote was not necessarily a disagreement with the FOMC decision on the fed funds rate, but more a call for more direct Fed action.

Introduction to The Federal Reserve System and Monetary Policy

[NOTE: The following material is summarized from the publication, "The Federal Reserve System: Purposes and Functions," published by the Board of Governors of the Federal Reserve System, Ninth Edition, 2005.]

The Federal Reserve System was created by Congress in 1913 "to provide the nation with a safer, more flexible, and more stable monetary and financial system." It is a federal system, composed of a central, governmental agency, the Board of Governors, in Washington, D.C., and twelve regional Federal Reserve Banks, located in major cities throughout the nation.

 The Federal Reserve’s duties fall into four general areas:

  • Conducting the nation’s monetary policy by influencing monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates.
  • Supervising and regulating banking institutions to ensure the safety and soundness of the nation’s banking and financial system and to protect the credit rights of consumers.
  • Maintaining the stability of the financial system and containing systemic risk that may arise in financial markets.
  • Providing financial services to depository institutions, the U.S. government, and foreign official institutions, including playing a major role in operating the nation’s payments system.

Most developed countries have a central bank whose functions are broadly similar to those of the Federal Reserve. The oldest, Sweden’s Riksbank, has existed since 1668 and the Bank of England since 1694. Napoleon I established the Banque de France in 1800, and the Bank of Canada began operations in 1935. The German Bundesbank was reestablished after World War II and is loosely modeled on the Federal Reserve. More recently, some functions of the Banque de France and the Bundesbank have been assumed by the European Central Bank, formed in 1998. 

The Creation of the Federal Reserve System

During the nineteenth century and the beginning of the twentieth century, financial panics plagued the nation, leading to bank failures and business bankruptcies that severely disrupted the economy. The failure of the nation’s banking system to effectively provide funding to troubled depository institutions contributed significantly to the economy’s vulnerability to financial panics. After the crisis of 1907, Congress established a commission and institution that would help prevent and contain financial disruptions.

Congress passed the Federal Reserve Act in “to provide for the establishment of Federal reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes.” President Woodrow Wilson signed the act into law on December 23, 1913.

The twelve Federal Reserve Banks and their Branches carry out a variety of System functions, including operating a nationwide payments system, distributing the nation’s currency and coin, supervising and regulating member banks and bank holding companies, and serving as banker for the U.S. Treasury. The twelve Reserve Banks are each responsible for a particular geographic area or district of the United States. Each Reserve District is identified by a number and a letter. Besides carrying out functions for the System as a whole, such as administering nationwide banking and credit policies, each Reserve Bank acts as a depository for the banks in its own District and fulfills other District responsibilities.

Federal Reserve Bank Districts

District District Location

Number Letter City

  1. A Boston, Massachusetts
  2. B New York, New York
  3. C Philadelphia, Pennsylvania
  4. D Cleveland, Ohio
  5. E Richmond, Virginia
  6. F Atlanta, Georgia
  7. G Chicago, Illinois
  8. H St. Louis, Missouri
  9. I Minneapolis, Minnesota
  10. J Kansas City, Missouri
  11. K Dallas, Texas
  12. L San Francisco, California

The Federal Reserve Board of Governors

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 current chairman of the Federal Reservce is Ben S. Bernanke, Ph.D. Dr. Bernanke was sworn in on February 1, 2006, as Chairman and a member of the Board of Governors of the Federal Reserve System. Dr. Bernanke also serves as Chairman of the Federal Open Market Committee. He was appointed as a member of the Board to a full 14-year term, which expires January 31, 2020, and to a four-year term as Chairman, which expires January 31, 2010. Before his appointment as Chairman, Dr. Bernanke was Chairman of the President's Council of Economic Advisers, from June 2005 to January 2006. 

The Federal Open Market Committee (FOMC)

A major component of the Federal Reserve System is the Federal Open Market Committee (FOMC), which is made up of the members of the Board of Governors, the president of the Federal Reserve Bank of New York, and presidents of four other Federal Reserve Banks, who serve on a rotating basis. The FOMC oversees open market operations, which is the main tool used by the Federal Reserve to influence money market conditions and the growth of money and credit. Traditionally, the Chairman of the Board of Governors serves as the Chairman of the FOMC. 

Federal Reserve Policy Tools

The Federal Reserve implements monetary policy through its control over the federal funds rate, the rate at which depository institutions trade balances at the Federal Reserve. It exercises this control by influencing the demand for and supply of these balances through the following means:

  • Open market operations:  the purchase or sale of securities, primarily U.S. Treasury securities, in the open market to influence the level of balances that depository institutions hold at the Federal Reserve Banks. Open market operations are used to meet the goal of the target federal funds rate. Open market operations are conducted by the Domestic Trading Desk at the Federal Reserve Bank of New York.
  • Reserve requirements:   requirements regarding the percentage of certain deposits that depository institutions must hold in reserve in the form of cash or in an account at a Federal Reserve Bank
  • Contractual clearing balances: an amount that a depository institution agrees to hold at its Federal Reserve Bank in addition to any required reserve balance
  • Discount window lending (discount rate): extensions of credit to depository institutions made through the primary, secondary, or seasonal lending programs

By trading government securities, the New York Fed affects the federal funds rate, which is the interest rate at which depository institutions lend balances to each other overnight. The Federal Open Market Committee establishes the target rate for trading in the federal funds market.

Figure 1 shows the recent history of the target federal funds rate through the January 28, 2009 target. Notice how the target rate has moved up and down in a cyclical patern. This pattern of change is strongly correlated with the business cycles, generally increasing during expansionary periods and decreasing during contractions. Figure 2 shows the recent business cycles as measured by change in real gross domestic product (GDP).

Federal Reserve Figure 1

Federal Reserve figure 2

How Monetary Policy Affects the Economy

The initial link in the chain between monetary policy and the economy is the market for balances held at the Federal Reserve Banks. Depository institutions have accounts at their Reserve Banks, and they actively trade balances held in these accounts in the federal funds market at an interest rate known as the federal funds rate. The Federal Reserve exercises considerable control over the federal funds rate through its influence over the supply of and demand for balances at the Reserve Banks.

The FOMC sets the federal funds rate at a level it believes will foster financial and monetary conditions consistent with achieving its monetary policy objectives, and it adjusts that target in line with evolving economic developments. A change in the federal funds rate, or even a change in expectations about the future level of the federal funds rate, can set off a chain of events that will affect other short-term interest rates, longer-term interest rates, the foreign exchange value of the dollar, and stock prices. In turn, changes in these variables will affect households’ and businesses’ spending decisions, thereby affecting growth in aggregate demand and the economy.

Short-term interest rates, such as those on Treasury bills and commercial paper, are affected not only by the current level of the federal funds rate but also by expectations about the overnight federal funds rate over the duration of the short-term contract. As a result, short-term interest rates could decline if the Federal Reserve surprised market participants with a reduction in the federal funds rate, or if unfolding events convinced participants that the Federal Reserve was going to be holding the federal funds rate lower than had been anticipated. Similarly, short-term interest rates would increase if the Federal Reserve surprised market participants by announcing an increase in the federal funds rate, or if some event prompted market participants to believe that the Federal Reserve was going to be holding the federal funds rate at higher levels than had been anticipated. 

Expansionary monetary policy actions: Decrease interest rates

  • Reduce the target fed funds rate
  • Open market operations: buy securities
  • Reduce reserve requirements
  • Decrease the discount rate

Contractionary monetary policy actions: Increase interest rates

  • Increase the target fed funds rate
  • Open market operations: sell securities
  • Increase reserve requirements
  • Increase the discount rate 

Changes in short-term interest rates will influence long-term interest rates, such as those on Treasury notes, corporate bonds, fixed-rate mortgages, and auto and other consumer loans. Long-term rates are affected not only by changes in current short-term rates but also by expectations about short-term rates over the rest of the life of the long-term contract. Generally, economic news or statements by officials will have a greater impact on short-term interest rates than on longer rates because they typically have a bearing on the course of the economy and monetary policy over a shorter period; however, the impact on long rates can also be considerable because the news has clear implications for the expected course of short-term rates over a longer time period.

In the current economic environment, negative GDP growth, decreasing employment and lack of adequate credit, the Fed has adopted a stimulatory policy. Given the very low level of interest rates, over the last year, the Federal Reserve has taken additional measures to open up financial markets and stimulate spending.

The Federal Reserve has established new programs to counter the "liquidity crisis" and the tight credit markets. These programs are intended to provide capital to different types of financial institutions "to strengthen market stability, improve the strength of financial institutions, and enhance market liquidity.

The first of these new Fed programs was the Term Auction Facility (TAF), created to improve bank liquidity. The TAF "allows a depository institution to place a bid for an advance from its local Federal Reserve Bank at an interest rate that is determined as the result of an auction. By allowing the Federal Reserve to inject term funds through a broader range of counterparties and against a broader range of collateral than open market operations, this facility could help ensure that liquidity provisions can be disseminated efficiently even when the unsecured interbank markets are under stress."

Click on the links below to find out more about each program's purpose and specific goals:

The common thread in these Fed programs' goals is to improve the balance sheets of financial institutions by supporting the value of their assets. One of the problems with bank holding has been uncertainty about the underlying value of the securities they hold. By replacing the banks' securities, such as mortgaged-backed securities, with those with more secure values, confidence in the banks will increase. In a more stable market with more predictable asset values, more narrowing and lending should result.

In a January 13, 2009, speech at the London School of Economics, called "The Crisis and the Policy Response," Fed Chairman Ben Bernanke called for a combination of central bank policies and government stimulus actions. His reference about the need for coordinated actions was not just to the U.S., but to all of the world's economic powers.

"The Federal Reserve will do its part to promote economic recovery, but other policy measures will be needed as well. The incoming Administration and the Congress are currently discussing a substantial fiscal package that, if enacted, could provide a significant boost to economic activity. In my view, however, fiscal actions are unlikely to promote a lasting recovery unless they are accompanied by strong measures to further stabilize and strengthen the financial system. History demonstrates conclusively that a modern economy cannot grow if its financial system is not operating effectively."

Click here for the full text of Dr. Bernanke's speech: The Crisis and the Policy Response

CONCLUSION

On January 28, 2009, The FOMC decided today to keep the target range for the federal funds rate at 0 to 1/4 percent. The Committee stated that continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time."

The FOMC decided to keep the fed funds target rate at the level set in December, 2008, primarily because further reducing the target rate to zero would be not have any real effect, given the current target and that the real market fed funds rate is near zero. Without further lowering of the fed funds rate as a tool to increase bank reserves and stimulate growth, the Federal Reserve must use other, non-traditional tools to implement its policy goals.

Given how low interest rates are now, further lowering of rates may not be enough (or possible) and a massive federal stimulus package is being debated in Congress. What do you think the government and Federal Reserve should do to "jump start" the economy?

ASSESSMENT ACTIVITY

Next, answer the essay question below on the interactive notepad.

 

  1. During a recessionary period, why would the Federal Reserve and FOMC choose to keep interest rates low?
     
  2. How do low interest rates help to achieve the Fed's goal to stimulate the economy and help banks?

EXTENSION ACTIVITY

From the map of The Twelve Federal Reserve Districts , identify the Federal Reserve Bank that serves your school's geographic area.

Explore your Federal Reserve Bank's web site for information about the economic health of their region and programs available to area businesses and consumers. Note: Some Federal Reserve banks have extensive educational resources and others do not.

  • Are conditions in your region similar, better or worse than national economic conditions? Growth? Employment? Price level?
  • Are there any particular characteristics about your region that impact it's economic health?
  • What do the president and/or other leaders of your Federal Reserve Bank have say about current conditions?
  • What programs and information services does your Federal Reserve Bank offer to consumers?