This lesson focuses on the September 23, 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, Central Banking System, Federal Reserve, Federal Reserve Structure, Macroeconomic Indicators, Monetary Policy, Open Market Operations, Reserve Requirements, Tools of the Federal Reserve

STUDENTS WILL

  • Explain the meaning of the September 23, 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 September 23, 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 September 23, 2009

Inflation

The U.S. Consumer Price Index for all Urban Consumers (CPI-U) rose 0.4 percent in August, 2009. The index has decreased 1.5 percent over the last 12 months on a not seasonally adjusted basis.

Employment and Unemployment

U.S. non-farm payroll employment continued to decline in August by 216,000 jobs, and the unemployment rate rose to 9.7 percent. Although job losses continued in many of the major industry sectors in August, the declines have moderated in recent months.

Real GDP

U.S. real gross domestic product decreased at an annual rate of 1.0 percent in the second quarter of 2009, according to the "second" 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

The September 23, 2009, Federal Open Market Committee (FOMC) "Monetary Policy" press release:

"Information received since the Federal Open Market Committee met in August suggests that economic activity has picked up following its severe downturn. Conditions in financial markets have improved further, and activity in the housing sector has increased. Household spending seems to be 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, though at a slower pace; they continue to make progress in bringing inventory stocks into better alignment with sales. Although economic activity is likely to remain weak for a time, the Committee anticipates that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will support a strengthening of economic growth and a gradual return to higher levels of resource utilization in a context of price stability."

The FOMC announcement began with an assessment of current economic conditions and the trends since August, 2009. The committee's conclusion was that the economy continues to be "weak" although the pace of problems seems to be moderating, and that continued monetary stimulus is required.

Is the recession over? Until the National Bureau of Economic Research "Business Cycle Dating Committee" declares that the business cycle has hit the bottom and begun to recover, the recession is not "officially" over. The NBER constantly monitors economic activity, including employment, GDP growth, etc. to assess the health of the economy. It was the NBER that identified the beginning of the current recession as December, 2007, but did so a year after that date. The recession may be over or it may not. In any case, growth is slow and employment continues to decline. This is what the FOMC members were thinking.

Inflation

The committee added that the potential for inflation is small. "With substantial resource slack likely to continue to dampen cost pressures and with longer-term inflation expectations stable, the Committee expects that inflation will remain subdued for some time." In the past, preventing inflation has been clearly identified as the Fed's number one objective. Some have feared that recent Fed policies would put pressures on prices to rise, but that has not happened to any significant degree.

Policy Actions

Next, the announcement identified it's policy recommendations. "In these circumstances, the Federal Reserve will continue to employ a wide range of 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. 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 $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency debt.  The Committee will gradually slow the pace of these purchases in order to promote a smooth transition in markets and anticipates that they will be executed by the end of the first quarter of 2010. As previously announced, the Federal Reserve’s purchases of $300 billion of Treasury securities will be completed by the end of October 2009. 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 bottom line: The federal funds rate target will remain the same range as was set in December, 2008, at 0 to 1/4 percent. The committee voted unanimously in favor of this policy statement.

National Economic Goals

The Employment Act of 1946 established the national economic goals of “maximum employment, production, and purchasing power." Among other things, the act requires the President to submit an annual economic report within ten days of the submission of the national budget that forecasts the future state of the economy, including employment, production, capital formation, and real income statistics. It created the Council of Economic Advisers, an appointed advisory board that will advise and assist the President in formulating economic policy, and the Joint Economic Committee, a committee composed of both senators and representatives instructed to review the government's economic policy at least annually.

The Federal Reserve System is responsible for implementation of policies to achieve the employment, growth and purchasing power goals. The Federal Reserve Board Chairman, currently Ben S. Bernanke, is required by law to regularly report to Congress on the activities of the Fed and progress toward the national economic goals.

Policies to stimulate or contract the economy fall into three categories, fiscal, monetary or regulatory. Fiscal policies involve government spending or using taxes to increase or slow down economic activity. Monetary policies are those policies that impact the money supply and interest rates. Regulations or incentives can be used to stimulate or control business activities.

 

Fiscal Policy Options
Stimulatory policies Reduce taxes or increase spending
Contractionary policies Increase taxes or reduce spending
Monetary Policy Options
Stimulatory policies Lower federal funds rate
Lower reserve requirements
Lower discount rate
Buy securities (open market securities)
Contractionary policies Increase federal funds rate
Increase reserve requirements
Increase discount rate
Sell securities (open market operations)
Regulatory Policy Options
Stimulatory policies Reduced regulation
Increased incentives
Contractionary policies

Increased regulation
Decreased incentives (disincentives)

 

Monetary Policy

The term "monetary policy" refers to the actions undertaken by a central bank, such as the Federal Reserve, to influence the availability and cost of money and credit to help promote national economic goals. The Federal Reserve Act of 1913 gave the Federal Reserve responsibility for setting monetary policy.

The Federal Reserve controls three tools of monetary policy, open market operations, the discount rate and bank reserve requirements. The Board of Governors of the Federal Reserve System is responsible for the setting the discount rate and bank reserve requirements, and the Federal Open Market Committee is responsible for open market operations. Using these tools, the Fed influences the demand for, and supply of, 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.

Changes in the federal funds rate trigger a chain of events that affect other short-term interest rates, foreign exchange rates, long-term interest rates, the amount of money and credit, and, ultimately, a range of economic variables, including employment, output, and prices of goods and services.

In an online publication, "The Federal Reserve's Response to the Financial Crisis," the Fed explains its recent expansion of policy actions. "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."

Figure 1 shows the recent history of the federal funds rate target. Note that the target has been quickly decreased from 5 1/4 percent in 2007 and to the current 0 to 1/4 percent that was set in December 2008.

 

Figure 1 Federal Reserve

 The three policy 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 depository institutions and other financial institutions. The Fed also provides liquidity directly to borrowers and investors in key credit markets through the Term Asset-Backed Securities Loan Facility, the Commercial Paper Funding Facility, the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, and the Money Market Investor Funding Facility.

Recently, 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. The September 23 announcement of the continued purchases of securities is an example of these actions.

[Note to teacher: To read more about the new Fed monetary policy tools and recent actions, go to Credit and Liquidity Programs .]

Open Market Operations

According to the Federal Reserve, "open market operations (OMOs) -- the purchase and sale of securities in the open market by a central bank -- are a key tool used by the Federal Reserve in the implementation of monetary policy." Historically, the Fed has used open market operations to adjust the supply of reserve balances so as to keep the federal funds rate around the target federal funds rate established by the Federal Open Market Committee (FOMC). Open market operations are conducted by the Trading Desk at the Federal Reserve Bank of New York.

"Permanent OMOs are generally used to accommodate the longer-term factors driving the expansion of the Federal Reserve's balance sheet -- primarily the trend growth of currency in circulation. Permanent OMOs involve outright purchases or sales of securities for the System Open Market Account, the Federal Reserve's portfolio. Temporary OMOs are typically used to address reserve needs that are deemed to be transitory in nature. These operations are either repurchase agreements (repos) or reverse repurchase agreements (reverse repos). Under a repo, the Trading Desk buys a security under an agreement to resell that security in the future. A repo is the economic equivalent to a collateralized loan, in which the difference between the purchase and sale prices reflects interest."

The Fed explains recent changes in monetary policy actions, "The Federal Reserve's approach to the implementation of monetary policy has evolved considerably since 2007, and particularly so since late 2008. The FOMC has established a near-zero target range for the federal funds rate, implying that the very large volume of reserve balances provided through the various liquidity facilities is consistent with the FOMC's funds rate objectives. In addition, open market operations have provided increasing amounts of reserve balances. Specifically, to help reduce the cost and increase the availability of credit for the purchase of houses, on November 25, 2008, the Federal Reserve announced that it would buy direct obligations of Fannie Mae, Freddie Mac, and the Federal Home Loan Banks and mortgage-backed securities (MBS) guaranteed by Fannie Mae, Freddie Mac, and Ginnie Mae."

Proving Liquidity to Banks

The Fed uses the discount window to "relieve liquidity strains for individual depository institutions and for the banking system as a whole by providing a source of funding in time of need." The Fed provides three types of discount window credit--primary credit, secondary credit, and seasonal credit. In December of 2007, the Federal Reserve introduced the Term Auction Facility (TAF), which provides credit to depository institutions through an auction mechanism. All regular discount window loans and TAF loans must be fully collateralized to the satisfaction of the lending Reserve Bank - the value of the collateral must exceed the value of the loan."

"Primary credit is a lending program available to depository institutions that are in generally sound financial condition. Because primary credit is available only to depository institutions in generally sound financial condition, it is generally provided with minimal administrative requirements; for example, there are essentially no usage restrictions on primary credit. Before the current financial crisis, primary credit was available on a very short-term basis, typically overnight, at a rate 100 basis points above the Federal Open Market Committee's (FOMC) target rate for federal funds. The primary credit facility helps provide an alternative source of funding if the market rate exceeds the primary credit rate, thereby limiting trading at rates significantly above the target rate."

"Secondary credit is available to depository institutions that are not eligible for primary credit. It is extended on a very short-term basis, typically overnight, at a rate 50 basis points above the primary credit rate. In contrast to primary credit, there are restrictions on the uses of secondary credit extensions. Secondary credit is available to meet backup liquidity needs when its use is consistent with a timely return by the borrower to a reliance on market sources of funding or the orderly resolution of a troubled institution. Secondary credit may not be used to fund an expansion of the borrower's assets. Moreover, the secondary credit program entails a higher level of Reserve Bank administration and oversight than the primary credit program."

The seasonal credit program "assists small depository institutions in managing significant seasonal swings in their loans and deposits. Eligible depository institutions may borrow term funds from the discount window during their periods of seasonal need, enabling them to carry fewer liquid assets during the rest of the year and, thus, allow them to make more funds available for local lending. The interest rate applied to seasonal credit is a floating rate based on market rates. Seasonal credit is available only to depository institutions that can demonstrate a clear pattern of recurring intra-yearly swings in funding needs. Eligible institutions are usually located in agricultural or tourist areas."

"On December 12, 2007, in view of pronounced strains in term bank funding markets, the Federal Reserve announced the creation of the Tern Auction Facility (TAF). Under the TAF program, the Federal Reserve auctions term funds to depository institutions. All depository institutions that are eligible to borrow under the primary credit discount window program are eligible to participate in TAF auctions. All advances must be fully collateralized with an appropriate haircut."

Note: A “haircut” is the difference between the value of a loan and the value of the collateral securing that loan – the spread or margin. An asset's market value may be reduced by this margin for the purpose of calculating a capital requirement, margin or level of required collateral.

How Do Federal Reserve Policies Impact the Economy?*

The Federal Reserve can't control inflation or influence output and employment directly. Instead, it affects them indirectly, mainly by raising or lowering a short-term interest rate called the "federal funds" rate. Most often, it does this through open market operations in the market for bank reserves, known as the federal funds market.

Banks and other depository institutions, such as banks, keep a certain amount of funds in reserve to meet unexpected outflows. Banks can keep these reserves as cash in their vaults or as deposits with the Fed. In fact, banks are required to hold a certain amount in reserves. But, typically, they hold even more than they're required to in order to clear overnight checks, restock ATMs, and make other payments.

From day to day, the amount of reserves a bank wants to hold may change as its deposits and transactions change. When a bank needs additional reserves on a short-term basis, it can borrow them from other banks that happen to have more reserves than they need. These loans take place in a private financial market called the federal funds market.

The interest rate on the overnight borrowing of reserves is called the federal funds rate or simply the "funds rate." It adjusts to balance the supply of and demand for reserves. For example, if the supply of reserves in the fed funds market is greater than the demand, then the funds rate falls, and if the supply of reserves is less than the demand, the funds rate rises.

Suppose the Fed wants the funds rate to fall. To do this, it buys government securities from a bank. The Fed then pays for the securities by increasing that bank's reserves. As a result, the bank now has more reserves than it wants. So the bank can lend these unwanted reserves to another bank in the federal funds market. Thus, the Fed's open market purchase increases the supply of reserves to the banking system, and the federal funds rate falls.

When the Fed wants the funds rate to rise, it does the reverse, that is, it sells government securities. The Fed receives payment in reserves from banks, which lowers the supply of reserves in the banking system, and the funds rate rises.

* Summarized from the Federal Reserve online publication, “About the Fed: What Are the Tools of U.S. Monetary Policy? ” 

How will the Fed Programs Help Consumers?

These Fed programs will not provide direct assistance to consumers. The TALF program will provide loans to investment companies to purchase securities that are backed by consumer debt. This will enable greater lending for purchases of automobiles, education loans, consumer credit purchases and small business loans. The loans will be to investors, such as hedge funds, private equity firms and mutual funds. The investors will work with the large banks and securities firms - the "primary dealers" who purchase securities directly from the Federal Reserve. As the securities are purchased, the banks and other firms that make consumer loans will have more available funds for loans directly to consumers - most likely at lower interest rates.

The current recession (beginning in December 2008) is characterized by reduced personal consumption expenditures and decreased private investment by firms and households. These problems are primarily a product of the frozen credit markets that resulted from the rapid decrease in housing prices and the resulting decrease in the value of the "mortgage-backed securities." Because the true value of many of these securities cannot be determined and the secondary markets for them are not effectively determine market prices, they cannot be bought and sold. Assets that have a value derived from an underlying security (a mortgage-backed security is based on the value of the pooled mortgages) are often referred to as "derivatives."

What Are Mortgage-backed Securities?

According to the U.S. Securities and Exchange Commission, mortgage-backed securities (MBS) are "debt obligations that represent claims to the cash flows from pools of mortgage loans, most commonly on residential property. Mortgage loans are purchased from banks, mortgage companies, and other originators and then assembled into pools by a governmental, quasi-governmental, or private entity. The entity then issues securities that represent claims on the principal and interest payments made by borrowers on the loans in the pool, a process known as securitization." [Source:  Mortgage Backed Securities ]

Other Key Terms Related to the Mortgage-Backed Securities Problem

A security is a tradable contract that carries a specified value. A security represents ownership (i.e., a stock), a debt agreement (i.e. bonds), or the rights of ownership is the process of taking an illiquid asset, or group of assets, and through financial engineering, transforming them into a security. A typical example of securitization is a mortgage-backed security (MBS), which is a type of asset-backed security that is secured by a collection of mortgages.

Securitization is the process of taking an illiquid asset, or group of assets, and through financial engineering, transforming them into a security. A typical example of securitization is a mortgage-backed security (MBS), which is a type of asset-backed security that is secured by the value of a group of mortgages.

Derivatives are financial instruments whose performance is derived, at least in part, from the performance of an underlying asset, security or index". [Source: Derivatives ]  For example, a mortgage-backed security is a derivative because its value changes based on price changes of the underlying group of mortgages.”

[Teacher Note: For a more thorough discussion of the impact of monetary policies in "Q and A" format, go to the Federal Reserve online publication " About the Fed:  How Does Monetary Policy Affect the U.S. Economy?

ASSESSMENT ACTIVITY

Essay Question:
1.  How does the Federal Reserve create money and stimulate the economy through open market operations?

[When the Federal Reserve purchases securities from financial institutions, the banks' reserves increase. With more reserves, the banks can make more loans, a process that increases the money supply. In normal times, an increase in the money supply lowers interest rates and stimulates borrowing and spending.]
 

CONCLUSION

The September 23, 2009, FOMC announcement reconfirmed the direction of monetary policy that has been in place since December 2008 and hinted that the worst may be over and recovery near.   

"Information received since the Federal Open Market Committee met in August suggests that economic activity has picked up following its severe downturn.  Conditions in financial markets have improved further, and activity in the housing sector has increased.  Household spending seems to be 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, though at a slower pace; they continue to make progress in bringing inventory stocks into better alignment with sales.  Although economic activity is likely to remain weak for a time, the Committee anticipates that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will support a strengthening of economic growth and a gradual return to higher levels of resource utilization in a context of price stability. "

"The Committee maintained the existing target range for the federal funds rate at 0 to 1/4 percent."

What will have to happen for the economy to turn around?

  • What will it take for consumers and businesses to be more confident?
  • Will more money or more liquidity solve the financial services industry problems?
  • Will consumers change their behavior and use credit more carefully?
  • Should credit markets be more regulated so that risk in the system is reduced?
  • Will we have learned from our past experiences with "bubbles" (dot.com, housing, etc.) to not rely on continuously increasing values as a basis for our investment and consumption decisions?

EXTENSION ACTIVITY

The Federal Reserve System includes twelve regional Federal Reserve Banks. For a map of the districts, go to The Twelve Federal Reserve Districts .  Click on the region where you live and you will go to the web site of your regional Federal Reserve Bank.

Each regional bank web site will have a variety of links to regional data, commentary on current conditions and historical economic data. Take a look at the information about your region.  

  • What are the region's strengths and weaknesses? 
  • What industries are doing well and/or suffering? 
  • What are the policy concerns of the Fed and banks in the region?

Look at the region's economic indicators - employment and regional GDP growth.

  • How is your region doing compared to the nation?
  • How is your region doing compared to neighboring regions?