This lesson focuses on the August 12, 2009, press release by the Federal Reserve System's Federal Open Market Committee (FOMC) on the current Federal Reserve monetary policy actions and goals. This lesson is intended to guide students and teachers through an analysis of the actions the Federal Reserve is taking and can take in influencing prices, employment, and economic growth. Through this lesson, students will better understand the dynamics of the U.S. economy, current economic conditions and monetary policies.

KEY CONCEPTS

Business Cycles, Discount Rate, Federal Reserve, Federal Reserve Structure, Monetary Policy, Open Market Operations, Price Stability, Reserve Requirements, Tools of the Federal Reserve

STUDENTS WILL

  • Explain the meaning of the August 12, 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.

Current Key Economic Indicators

as of May 5, 2013

Inflation

On a seasonally adjusted basis, the Consumer Price Index for All Urban Consumers decreased 0.2 percent in March after increasing 0.7 percent in February. The index for all items less food and energy rose 0.1 percent in March after rising 0.2 percent in February.

Employment and Unemployment

Total nonfarm payroll employment rose by 165,000 in April, and the unemployment rate was little changed at 7.5 percent. Employment increased in professional and business services, food services and drinking places, retail trade, and health care.

Real GDP

Real gross domestic product increased at an annual rate of 2.5 percent in the first quarter of 2013 (that is, from the fourth quarter to the first quarter), according to the "advance" estimate released by the Bureau of Economic Analysis. In the fourth quarter, real GDP increased 0.4 percent.

Federal Reserve

To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens. In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent...

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 August 12, 2009, press release by the Federal Open Market Committee on the current Federal Reserve monetary policy actions and goals.

[Note to teacher: In the first semester of the 2009-2010 school year (August-December), there will be four Focus on Economic Data lessons regarding the Federal Reserve and Monetary Policy. In addition to reporting the most recent FOMC decision, this focus on economic data will include an introduction to the structure and functions of the Federal Reserve System, the FOMC and monetary policy tools.

Lessons in September, November, and December, 2009, will address more specific issues of Fed policy tools, policy options, and new Fed programs to counter recessionary pressures and the current financial market problems.

MATERIALS


Key Economic Indicators

as of August 14, 2009

Inflation

On a seasonally adjusted basis, the CPI-U was unchanged in July after rising 0.7 percent in June. The index for all items less food and energy increased 0.1 percent in July after increasing 0.2 percent in June.

Employment and Unemployment

Nonfarm payroll employment continued to decline in July (-247,000), and the unemployment rate was little changed at 9.4 percent. The average monthly job loss for May through July (-331,000) was about half the average decline for November through April (-645,000).

Real GDP

Real gross domestic product decreased at an annual rate of 1.0 percent in the second quarter of 2009, (from the first quarter to the second), according to the "advance" estimate released by the Bureau of Economic Analysis. In the first quarter, real GDP decreased 6.4 percent.

Federal Reserve

The FOMC will "maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period."

PROCESS

Federal Open Market Committee Press Release:  August 12, 2009

The FOMC announcement began with an assessment of the key economic indicators that played a role in the committee's desision and announcement at the August 11-12 meeting.

"Information received since the Federal Open Market Committee met in June suggests that economic activity is leveling out. Conditions in financial markets have improved further in recent weeks. Household spending has continued to show signs of stabilizing but remains constrained by ongoing job losses, sluggish income growth, lower housing wealth, and tight credit. Businesses are still cutting back on fixed investment and staffing but are making progress in bringing inventory stocks into better alignment with sales. Although economic activity is likely to remain weak for a time, 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."
 
Analysts and news commentators have generally characterized the Fed's August announcement as a positive view of near-term and long-term economic health.  Conditions such as employment, growth, housing and business activity are improving.  An August 12, New York Time article by Edmund L. Andrews, "Fed Views Recession as Near an End," commented, "Though the central bank stopped well short of declaring victory, policy makers issued their most upbeat assessment in more than a year by saying that the downturn appears to have hit bottom and that consumer spending, financial markets and inventory-building by corporations all continued to stabilize."

The FOMC announcement also commented on the near-term prospects for low inflation, "The prices of energy and other commodities have risen of late. However, substantial resource slack is likely to dampen cost pressures, and the Committee expects that inflation will remain subdued for some time."

The FOMC held the federal funds rate at the same 0 to .1/4 percent level it established in December of 2008. "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 continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period."
 
A key signal of future policy was the FOMC's comment on the use of Treasury securities purchases to provide liquidity to credit markets.  "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 is in the process of buying $300 billion of Treasury securities. To promote a smooth transition in markets as these purchases of Treasury securities are completed, the Committee has decided to gradually slow the pace of these transactions and anticipates that the full amount will be purchased by the end of October. 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 monitoring the size and composition of its balance sheet and will make adjustments to its credit and liquidity programs as warranted."

The vote among the FOMC members was unanimous. "Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Donald L. Kohn; Jeffrey M. Lacker; Dennis P. Lockhart; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen."

Introduction to The Federal Reserve System, the FOMC, and Monetary Policy 

[Note to teacher: Much of 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 re-discounting 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 regional 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 Reserve 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 had been Chairman of the President's Council of Economic Advisers, from June 2005 to January 2006. 

The Federal Open Market Committee (FOMC)

An important 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. The target rate is currently set at a 0 to 1/4 percent range.

Figure 1 shows the recent history of the target federal funds rate through the August 12, 2009 target rate. Notice how the target rate has normally moved up and down in a cyclical pattern. 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).

 Figure 1

Figure 2

 [Note to teacher: The vertical axis of figure 2 has been revised form previous similar figuresto accommodate the -3.8 GDP change in Q4 of 2008 and the -6.5 change in Q1 of 2009.] 

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 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.

ASSESSMENT ACTIVITY

Essay Questions:
1.  During a recessionary period, why would the Federal Reserve and FOMC choose to keep interest rates low?

[Lower interest rates are an incentive for consumers to purchase and for businesses to invest in new productive capacity.]

2.  How do low interest rates help to achieve the Fed's goal to stimulate the economy and help banks?

[If banks have more excess reserves to lend, other market rates will fall. When credit markets are tight, either because funds are not available or lenders are reluctant to take risks, economic activity (output) slows, unemployment increases and people are uncertain about their economic futures. The Fed's stimulatory policies seek to encourage people to spend, businesses to invest and banks to make more loans.]
 

CONCLUSION

The August 12 FOMC announcement was the most positive monetary policy statement in the past two years. While the FOMC did not say that U.S. economic conditions are "good," it used the term "leveling off" to indicate that conditions are not expected to get worse.

The FOMC cited several indicators of a more positive turn in the economy:

  • "Conditions in financial markets have improved further in recent weeks."
  • "Household spending has continued to show signs of stabilizing but remains constrained by ongoing job losses"
  • "Sluggish income growth, lower housing wealth, and tight credit."
  • "Businesses are still cutting back on fixed investment and staffing but are making progress in bringing inventory stocks into better alignment with sales."


The current Federal Reserve efforts to stabilize financial institutions will continue with "fiscal and monetary stimulus."  The statement indicated future direction, or, at least hope, when suggesting that "market forces will contribute to a gradual resumption of sustainable economic growth in a context of price stability."

EXTENSION ACTIVITY

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

Students can explore their Federal Reserve Bank's web site for information about the economic health of their region and programs available to area businesses and consumers. [Note to teacher: 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 reegion 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?