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 April 29, 2009, press release by the Federal Open Market Committee on the current Federal Reserve monetary policy actions and goals.

TASK

  • Explain the meaning of the April 29, 2009 Federal Open Market Committee decision concerning the target for the federal funds rate.
  • Identify the current monetary policy goals of the Federal Reserve and the factors that have recently influenced monetary policy goals.
  • Explain the structure and functions of the Federal Reserve System, Federal Reserve Banks, and the Federal Open Market Committee.
  • Identify the monetary policy options and other tools available to the Federal Reserve to stimulate or contract the economy.

PROCESS

 The Federal Reserve System's Federal Open Market Committee (FOMC) has now kept the target federal funds rate at 0 to 1/4 percent for five months, since December 16, 2008. The FOMC lowered the target federal funds rate just days after the National Bureau of Economic Research (NBER) Business Cycle Dating Committee declared that the recession had begun in December 2007. With the target rate so low, there is little the Fed can do using traditional open market operations or the discount rate to increase the money supply and promote lending. The announcement after the April 29 FOMC meeting stressed the actions being taken in the absence of inflationary pressures to provide bank liquidity in support of mortgage lending and credit markets.

Federal Open Market Committee, Monetary Policy News Release, April 29, 2009

"Information received since the Federal Open Market Committee met in March indicates that the economy has continued to contract, though the pace of contraction appears to be somewhat slower. Household spending has shown signs of stabilizing but remains constrained by ongoing job losses, lower housing wealth, and tight credit. Weak sales prospects and difficulties in obtaining credit have led businesses to cut back on inventories, fixed investment, and staffing. Although the economic outlook has improved modestly since the March meeting, partly reflecting some easing of financial market conditions, economic activity is likely to remain weak for a time. Nonetheless, the Committee continues to anticipate that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will contribute to a gradual resumption of sustainable economic growth in a context of price stability."

"In light of increasing economic slack here and abroad, the Committee expects that inflation will remain subdued. 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."

"In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability. The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period. As previously announced, to provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve will purchase a total of up to $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency debt by the end of the year. In addition, the Federal Reserve will buy up to $300 billion of Treasury securities by autumn. The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets. The Federal Reserve is facilitating the extension of credit to households and businesses and supporting the functioning of financial markets through a range of liquidity programs. The Committee will continue to carefully monitor the size and composition of the Federal Reserve's balance sheet in light of financial and economic developments."

Click on this link to review past FOMC Monetary Policy News Releases .

Figure 1 shows the history of the target federal funds rate from 1990 to the present level of 0 to 1/4 percent.  Note how the target rate has been moved up and down as the Federal Reserve has responded to inflationary pressures or slow growth at different periods of time.  As recently as December,2007, at the beginning of the recession, the target federal funds rate was 4.25 percent.  The current target rate is a record low.

FOMC Figure 1
 

Open Market Operations 

 Open market operations are the Federal Reserve's primary tool for implementing monetary policy.  The Fed web page briefly explains the objective of open market operations.  "“Open market operations--purchases and sales of U.S. Treasury and federal agency securities--are the Federal Reserve's principal tool for implementing monetary policy. The short-term objective for open market operations is specified by the Federal Open Market Committee (FOMC). This objective can be a desired quantity of reserves or a desired price (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."

The Federal Reserve's objective for open market operations has varied over the years. During the 1980s, the focus gradually shifted toward attaining a specified level of the federal funds rate, a process that was largely complete by the end of the decade. Beginning in 1994, the FOMC began announcing changes in its policy stance, and in 1995 it began to explicitly state its target level for the federal funds rate. Since February 2000, the statement issued by the FOMC shortly after each of its meetings usually has included the Committee's assessment of the risks to the attainment of its long-run goals of price stability and sustainable economic growth.”  Source:  The Federal Reserve's page "Open-Market Operations ."

 

Bank Reserves and the Fed Funds Rate

Banks are required by law to keep some of their reserves in an account with Federal Reserve or as cash in their vaults. The required reserve level is determined by their outstanding assets and liabilities and the minimum level set by the Fed - typically equal to about 10% of their demand accounts. The actual requirement can vary by the size of the bank. Any reserves beyond the minimum requirement are “excess reserves” that are available to make loans.

 

When a bank makes a loan, its reserves decrease. If its reserves drop below the required minimum, it must accumulate additional reserves to meet the Fed’s requirement. The bank can borrow the needed funds from another bank that has a surplus of (excess) reserves. The interest rate a bank pays when it borrow funds from another bank is negotiated between the two banks. The average of these negotiated rates is the effective federal funds rate.

 

The target federal funds rate set by FOMC is maintained through open market operations. By purchasing or selling securities, the Fed can influence the level of bank reserves, and thus, the level of the federal funds rate.  The FOMC will increase or decrease the target rate depending on economic conditions and the Fed’s overall monetary policy goals. The Fed doesn’t actually set the rate, but can influence the rate through open market operations. When a bank buys securities, from the Fed, it then has fewer funds to loan. When a bank sells securities to the Fed, it then has more funds (reserves) to loan.

 

An alternative for banks that must increase their reserves is to borrow directly from the Federal Reserve through the “discount window.” The discount rate is typically slightly higher than the federal funds rate. The FOMC will typically set the discount rate as it establishes a target for the federal funds rate.


What Happens at a FOMC Meeting?

After each FOMC meeting and announcement, the meeting minutes are prepared and released about three weeks later. The minutes often provide insight into the focus of the meeting and the factors that influenced the FOMC decision. The minutes contain staff reports and committee discussion. As an example, the minutes of the March 17-18 FOMC meeting contained these staff comments on economic conditions at that time.

“Staff reported on recent developments in System liquidity programs and on changes in the System's balance sheet. As of March 12, the System's total assets and liabilities were about $2 trillion, close to the level of that just before the January 27-28 meeting…Most meeting participants interpreted the evidence as indicating that credit markets still were not working well, and that the Federal Reserve's lending programs, asset purchases, and currency swaps were providing much-needed support to economic activity by reducing dislocations in financial markets, lowering the cost of credit, and facilitating the flow of credit to businesses and households. Participants discussed the prospective further increase in the Federal Reserve's balance sheet, with a focus on the Term Asset-Backed Securities Loan Facility (TALF) and open market purchases of longer-term assets.” 

The Staff Comments on the Key Sectors and Data

The information reviewed at the March 17-18 meeting indicated that economic activity had fallen sharply in recent months. The contraction was reflected in widespread declines in payroll employment and industrial production. Consumer spending appeared to remain at a low level after changing little, on balance, in recent months. The housing market weakened further, and nonresidential construction fell. Business spending on equipment and software continued to fall across a broad range of categories. Despite the cutbacks in production, inventory overhangs appeared to worsen in a number of areas. Both headline and core consumer prices edged up in January and February.”

The staff report then went into detail on each factor: “Labor market conditions continued to deteriorate. Private payroll employment dropped considerably over the three months ending in February. Employment losses remained widespread across industries, with the notable exception of health care.”

Industrial production fell in January and February, with cutbacks again widespread, and capacity utilization in manufacturing declined to a very low level. Although production of light motor vehicles turned up in February, it remained well below the pace of the fourth quarter as manufacturers responded to the significant deterioration in demand over the past few months. The output of high-tech products declined as production of computers and semiconductors extended the sharp declines that began in the fourth quarter of 2008. The production of other consumer durables and business equipment weakened further, and broad indicators of near-term manufacturing activity suggested that factory output would continue to contract over the next few months.”

The available data suggested that real consumer spending held steady, on balance, in the first two months of this year after having fallen sharply over the second half of last year. Real spending on goods excluding motor vehicles was estimated to have edged up, on balance, in January and February. In contrast, real outlays on motor vehicles contracted further in February after a decline in January. The financial strain on households intensified over the previous several months; by the end of the fourth quarter, household net worth for the first time since 1995 had fallen to less than five times disposable income, and substantial declines in equity and house prices continued early this year.”

Housing activity continued to be subdued. Single-family starts ticked up in February, and adjusted permit issuance in this sector moved up to a level slightly above starts. Multifamily starts jumped in February from the very low level in January, and the level of multifamily starts was close to where it had been at the end of the third quarter of 2008. Housing demand remained very weak, however. Although the stock of unsold new single-family homes fell in January to its lowest level since 2003, inventories continued to move up relative to the slow pace of sales. Sales of existing single-family homes fell in January, reversing the uptick seen in December.”

Business spending on transportation equipment continued to fall from already low levels, and demand both for high-tech equipment and software and for equipment other than high-tech and transportation dropped sharply in the fourth quarter. In January, nominal shipments of nondefense capital goods excluding aircraft declined, and new orders fell significantly further.”.

The U.S. international trade deficit narrowed in December and January, as a steep fall in imports more than offset a decline in exports. All major categories of exports decreased, especially sales of industrial supplies, machinery, and automotive products. All major categories of imports decreased as well, with large declines in imports of oil, automotive products, and industrial supplies.”

Output in the advanced foreign economies contracted in the fourth quarter, with large reductions in real gross domestic product (GDP) in all the major economies and a double-digit rate of decline in Japan. Trade and investment in those countries were particularly weak. Indicators of economic activity, especially industrial production, suggested that the pace of contraction accelerated late in the fourth quarter and into the first quarter. Economic activity in emerging market economies also weakened significantly in the fourth quarter.

“In the United States, overall consumer prices increased in January and February, led by an increase in energy prices, after posting sizable declines late last year. Excluding the categories of food and energy, consumer prices edged higher in January and February after three months of no change. The producer price index for core intermediate materials dropped for a fifth month in February, reflecting, in part, weaker global demand and steep declines in the prices of a wide variety of energy-intensive goods, such as chemicals and plastics. Low readings on overall and core consumer price inflation in recent months, as well as the weakened economic outlook, kept near-term inflation expectations reported in surveys well below their high levels in mid-2008. In contrast, measures of longer-term expectations remained close to their averages over the past couple of years. Hourly earnings continued to increase at a moderate rate in February.”

Much of the report details the data provided by the staff and discussion by the FOMC members. At the end of the meeting, the committee votes on the announcement and the directions given to the Federal Reserve Bank of New York trading desk to implement the FOMC's policy goals. “At the conclusion of the discussion, the Committee voted to authorize and direct the Federal Reserve Bank of New York, until it was instructed otherwise, to execute transactions in the System Account in accordance with the following domestic policy directive:

The April 29 FOMC Policy Directions

"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 seeks conditions in reserve markets consistent with federal funds trading in a range from 0 to 1/4 percent. The Committee directs the Desk to purchase GSE (government sponsored enterprises) debt, GSE-guaranteed MBS, and longer-term Treasury securities during the inter-meeting period with the aim of providing support to private credit markets and economic activity. The timing and pace of these purchases should depend on conditions in the markets for such securities and on a broader assessment of private credit market conditions. The Committee anticipates that the combination of outright purchases and various liquidity facilities outstanding will cause the size of the Federal Reserve's balance sheet to expand significantly in coming months.”

Note:  Government-sponsored enterprises (GSE) include the Federal National Mortgage Association's (Fannie Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac), the Farm Credit System, Federal Home Loan Bank, and other similar agencies.  These agencies were created by Congress to provide flows of credit to targeted sectors of the economy.  

[For more information about Fannie Mae and Freddie Mac, the GSEs most directly involved in the mortgage crisis, go to their web sites:
Fannie Mae
Freddie Mac ]

Click here for the link to the Full Minutes of the March 17-18, 2009 FOMC Meeting .

 
Fed Response to the Financial Crisis


The Federal Reserve has designed a variety of new programs (the Fed calls them tools) beyond the traditional monetary policy tools in response to the current financial crisis.  The Fed web site explains, "The Federal Reserve has responded aggressively to the financial crisis since its emergence in the summer of 2007. The reduction in the target federal funds rate from 5-1/4 percent to effectively zero was an extraordinarily rapid easing in the stance of monetary policy. In addition, the Federal Reserve has implemented a number of programs designed to support the liquidity of financial institutions and foster improved conditions in financial markets. These new programs have led to a significant change to the Federal Reserve’s balance sheet."

"The first set of tools, which are closely tied to the central bank's traditional role as the lender of last resort, involve the provision of short-term liquidity to banks and other financial institutions. Because bank funding markets are global in scope, the Federal Reserve has also approved bilateral currency swap agreements with 14 foreign central banks. These swap arrangements assist these central banks in their provision of dollar liquidity to banks in their jurisdictions.

A second set of tools involve the provision of liquidity directly to borrowers and investors in key credit markets. The Commercial Paper Funding Facility, the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, the Money Market Investor Funding Facility, and the Term Asset-Backed Securities Loan Facility fall into this category. All of the programs are described in detail elsewhere on this website.

As a third set of instruments, the Federal Reserve has expanded its traditional tool of open market operations to support the functioning of credit markets through the purchase of longer-term securities for the Federal Reserve's portfolio. For example, on November 25, 2008, the Federal Reserve announced plans to purchase up to $100 billion in government-sponsored enterprise (GSE) debt and up to $500 billion in mortgage-backed securities. On March 18, the Federal Reserve announced plans to purchase up to $300 billion of longer-term Treasury securities in addition to increasing its total purchases of GSE debt and mortgage-backed securities to up to $200 billion and $1.25 trillion, respectively."

The Fed and the U.S. Treasury are creating ways to support financial institutions by finding ways to buy or guarantee the value of so-called "toxic assets."  These include hundreds of billions of dollars of mortgage backed securities that banks hold but are difficult, if not impossible, to sell in the current market conditions.  By replacing the "toxic assets" on bank balance sheets with more liquid assets, the banks will be more able to engage in their primary activity - lending.

CONCLUSION

The federal funds rate remains at a historic low level, and the Federal Reserve and U.S. Treasury have initiated programs to support the banking industry, encourage lending and borrowing, and stimulate economic growth as the economy continues to contract (see the most recent Focus on Economic Data lesson on "Real GDP Growth."

The Fed has recognized that there is little risk of inflation, traditionally its number one target, and that an aggressive stimulatory policy is needed.  Get more money into the hands of businesses to invest and consumers to spend.  Ink liquidity by removing toxic assets from the system and improve bank stability.

The Fed statement provided a long list of evidence that the economy has problems:  "...ongoing job losses, lower housing wealth, and tight credit. Weak sales prospects and difficulties in obtaining credit have led businesses to cut back on inventories, fixed investment, and staffing... the Committee continues to anticipate that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will contribute to a gradual resumption of sustainable economic growth in a context of price stability."

The FOMC added, "In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability."

What do you think the Federal Reserve should do to stimulate growth, promote job growth and maintain price stability?

ASSESSMENT ACTIVITY

Next, answer the essay question on the interactive notepad.


1. What is the purpose of the FOMC's target federal funds rate?

EXTENSION ACTIVITY

The Federal Reserve has published a web-based resource for teachers and students called "Federal Reserve Education ".

Federal Reserve Education includes sections on the history of the Fed, the structure of the Fed, monetary policy, bank supervision, and financial services.

  1. Click on the link to "Monetary Policy."  Click on the link and review the "Basics of Monetary Policy." 
  2. Click on "How does the Fed create money?" to learn how Fed actions can influence the money supply.
  3. Click on "Economic Indicators" to review the meaning of gross domestic product, consumer price index, unemployment rate and other economic indicators. 

This will help you better understand the monetary policy goals and actions of the Fed in the context of economic conditions, such as those discussed at the FOMC meetings.

Federal Reserve Education includes a link to a web page named "National Economic Indicators " that lists key economic indicators and additional links to the current data for each indicator.