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.

The FOMC has maintained the target federal funds rate at a range of 0 to 1/4 percent since its December 16, 2008 meeting.  The fed funds rate has been kept at this historically low level due to over a year of low and often negative real GDP growth, significant numbers of non-farm employment losses and very high unemployment.

This lesson focuses on the March 16, 2010, press release by the Federal Open Market Committee on the current Federal Reserve monetary policy actions and goals.

TASK

  • Explain the meaning of the March 16, 2010, 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

Focus on Economics Data: Monetary Policy

 Is no news good news?

The Federal Open Market Committee’s monetary policy statements are beginning to sound very familiar. The words “maintain the target range for the federal funds rate at 0 to ¼ percent” and “exceptionally low levels of the federal funds rate for an extended period” been repeated for many months. The current federal funds rate target range was established by the FOMC at 0 to ¼ on December 16, 2008.

Remember - the federal funds target rate is the interest rate at which depository institutions (banks, etc.) lend balances (excess reserves) at the Federal Reserve to other depository institutions overnight. The purpose of these overnight loans is to allow depository institutions to meet their reserve requirements.

If a bank makes a loan, its reserves decrease. If the bank’s reserve ratio drops below the minimum required by the Fed, it must add to its reserves. The bank can borrow reserves from another bank that has a surplus of reserves in its account with the Fed. The interest rate the borrowing bank pays to the lending bank is negotiated between the two banks. The weighted average of all of these negotiated rates is the federal funds effective rate. The FOMC sets a target rate or target range, and uses open market operations to influence bank reserves and the determination of the effective rate.

[Note to teacher:  Ask your students if they think this sounds like good news for the economy?]

For the past fifteen months, the FOMC has used its policy tools to keep the effective fed funds rate as close to zero as it can. Why keep it so low? The March 16 FOMC statement explains…

Federal Reserve System Monetary Policy Press Release

Release Date: March 16, 2010

“Information received since the Federal Open Market Committee met in January suggests that economic activity has continued to strengthen and that the labor market is stabilizing. Household spending is expanding at a moderate rate but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit. Business spending on equipment and software has risen significantly. However, investment in nonresidential structures is declining, housing starts have been flat at a depressed level, and employers remain reluctant to add to payrolls. While bank lending continues to contract, financial market conditions remain supportive of economic growth. Although the pace of economic recovery is likely to be moderate for a time, the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability.”

What does this mean?

  • Economic activity has “continued to strengthen.” Real GDP is growing, but not yet at its level prior to the recession.
  • The labor market is “stabilizing.” The number of monthly job losses is decreasing and the unemployment rate has dropped slightly.
  • “Lower housing wealth.” Home values almost everywhere are still considerably lower than prior to the current crisis.
  • “Tight credit.” Banks are not lending enough to stimulate enough economic activity.
  • Nonresidential investment is “declining.” Businesses are not investing plants, equipment, etc. to increase future output and employment.
  • A “gradual return” to higher levels of resource utilization. We are not yet using all (enough) of our resources to grow the economy and put people to work.
  • In a context of “price stability.” The Fed continues to be vigilant about signs of inflation – its traditional “number 1” enemy. As long as there are no significant signs of inflation, the Fed will work to keep interest rates low.

The statement concluded...

“With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to be subdued for some time.”

The FOMC monetary policy decision – the federal funds rate target.

“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, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.”

How will the Fed achieve this goal?

“To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve has been purchasing $1.25 trillion of agency mortgage-backed securities and about $175 billion of agency debt; those purchases are nearing completion, and the remaining transactions will be executed by the end of this month. The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to promote economic recovery and price stability.”

Some of the new Fed tools may no longer be necessary.

“In light of improved functioning of financial markets, the Federal Reserve has been closing the special liquidity facilities that it created to support markets during the crisis. The only remaining such program, the Term Asset-Backed Securities Loan Facility, is scheduled to close on June 30 for loans backed by new-issue commercial mortgage-backed securities and on March 31 for loans backed by all other types of collateral.”

All but one of the members of the FOMC voted for this statement. One member, Thomas M. Hoenig (President of the Federal Reserve Bank of Kansas City), vote against the statement. He did not like the inclusion of the phrase, “are likely to warrant exceptionally low levels of the federal funds rate for an extended period.” He argued that it may “lead to the buildup of financial imbalances and increase risks to longer-run macroeconomic and financial stability.” 

The March 16 FOMC statement confirmed what most economists and commentators expected, no change in the federal funds rate target. With no anticipation of inflationary pressures, the FOMC decided that low interest rates are appropriate and that programs to support mortgage lending and credit markets will continue.

The March estimate by the Bureau of Labor Statistics (BLS) that the U.S. unemployment rate remains near 10 percent underscores the Fed's concern about the state of the economy and the need for further stimulus facilitated by low interest rates. Unemployment typically is a lagging economic indicator - not indicating further future problems, but telling us that things have not improved as much as had been hoped. Continued high unemployment has caused many to think that the economic recovery may take longer than historically normal.

Figure 1, below, shows the recent history of the target federal funds rate. Note the exceptionally low rate (range of 0-1/4 percent) that has been in effect since December 2008. The up and down fluctuations over time generally mirror the business cycles, as monetary policy is used to promote growth or slow price level increases.

Figure 1 FOMC

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: Open Market Operations

With the target range for the federal funds rate at such a low level and the real rate exceptionally low, there is not much potential for use of the typical monetary policy tools to stimulate growth. The Fed has made unprecedented efforts to stabilize credit markets, improve liquidity and encourage lending.

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 statement, 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 January 6, 2010, FOMC meeting contained these staff comments on economic conditions at that time. The January minutes were released February 17, 2010.

“...the projected pace of real output growth in 2010 and 2011 was expected to exceed that of potential output by only enough to produce a very gradual reduction in economic slack.”

“…the staff continued to project that core inflation would slow somewhat from its current pace over the next two years. Moreover, the staff expected that headline consumer price inflation would decline to about the same rate as core inflation in 2010 and 2011.”

The FOMC relies on the research staff to assess current conditions and suggest the impact in the future. In this case, the staff report cited improving output but continued low levels of output. The staff looks at a variety of economic data, paying particular attention to output, employment and price level.

The following is a sample from the January 6 FOMC meeting minutes, describing the committee’s discussion. Note the kinds of comments made and how the discussion is characterized. The meeting minutes give analysts better information about the committee members’ thoughts and the data they felt was important.

“Most participants anticipated that substantial slack in labor and product markets, along with well-anchored inflation expectations, would keep inflation subdued in the near term, although they had differing views as to the relative importance of those two factors. The decelerations in wages and unit labor costs this year, and the accompanying deceleration in marginal costs, were cited as factors putting downward pressure on inflation. Moreover, anecdotal evidence suggested that most firms had little ability to raise their prices in the current economic environment.”

Conclusion: Little current pressure on prices and inflation.

“Some participants noted, however, that rising prices of oil and other commodities, along with increases in import prices, could boost inflation pressures going forward. Overall, many participants viewed the risks to their inflation outlooks as being roughly balanced. Some saw inflation risks as tilted to the downside, reflecting the quite elevated level of economic slack and the possibility that inflation expectations could begin to decline in response to the low level of actual inflation. But others felt that inflation risks were tilted to the upside, particularly in the medium term, because of the possibility that inflation expectations could rise as a result of the public’s concerns about extraordinary monetary policy stimulus and large federal budget deficits. Moreover, a few participants noted that banks might seek, as the economy improves, to reduce their excess reserves quickly and substantially by purchasing securities or by easing credit standards and expanding their lending.”

Conclusion: The committee members did not agree on the future prospect for inflation.

“A rapid shift, if not offset by Federal Reserve actions, could give excessive impetus to spending and potentially result in expected and actual inflation higher than would be consistent with price stability. To keep inflation expectations anchored, all participants agreed that monetary policy would need to be responsive to any significant improvement or worsening in the economic outlook and that the Federal Reserve would need to continue to clearly communicate its ability and intent to begin withdrawing monetary policy accommodation at the appropriate time and pace.”

 Conclusion: The Fed should be cautious, not overreact, but be ready to act if necessary.

“Although members generally saw little risk that maintaining very low short-term interest rates could raise inflation expectations or create instability in asset markets, they noted that it was important to remain alert to these risks. All agreed that the path of short-term rates going forward would depend on the evolution of the economic outlook.”

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.

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.

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.

As the March 16 statement mentioned, the FOMC has established a time line to end these extraordinary programs and rely more on market forces to continue stabilizing financial markets and provide support for the banking system.

Some Key Terms From the Federal Reserve Monetary Policy Announcement

  • Fixed investment in refers to investment in fixed capital, capital used for production or residential buildings, or to the replacement of depreciated capital goods. (machinery, land, buildings, installations, vehicles, or technology)
  • Inventory consists of raw materials, work-in-process goods, and finished goods that are a business's assets that are ready or will be ready for sale. The sale of inventory is a source of revenue and earnings for the company.
  • Resource utilization – the Fed report referred to low rates of resource utilization. This represents the output gap, or the difference between actual and potential GDP when resources, primarily labor and capital, are not being use to their full capacity. 
    You may also hear the term “capacity utilization.” This refers to percentage of the economy's total plant and equipment that is currently in production. Usually, a decrease in this percentage signals an economic slowdown, while an increase signals economic expansion
  • Agency debt is a security, usually a bond, issued by a U.S. government-sponsored agency. The offerings of these agencies are backed by the government, but not guaranteed by the government since the agencies are private entities. Some prominent issuers of agency securities are Student Loan Marketing Association (Sallie Mae), Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac).
  • Mortgage-backed securities are assets backed security or debt obligations that represents a claim on the cash flows from mortgage loans, most commonly on residential property. Mortgage loans are purchased from banks, mortgage companies, and other originators, and then are assembled into pools. The securities are usually sold as bonds, but financial innovation has created a variety of securities that derive their ultimate value from mortgage pools.
  • Balance sheet refers to a financial statement of the assets, liabilities and net worth of an individual or organization on a given date. The Federal Reserve has “balance sheet” consisting of its assets and liabilities. The Fed’s balance sheet has grown as it has accumulated assets, such as mortgage-backed securities, from financial institutions.

These definitions are taken from various Federal Reserve publications and online resources. For more definitions of key Federal Reserve, banking and financial terms, go to the online Federal Reserve Education Glossary .

CONCLUSION

The March 16, 2010, FOMC monetary policy statement confirmed what many economists, analysts, and news commentators expected, no change in the federal funds rate target. With no anticipation of inflationary pressures, the FOMC decided that low interest rates are appropriate to stiulate economic activity, and that some programs to support mortgage lending and credit markets will continue. The FOMC's rationale was similar to recent announcements, yet providing some hope that there has been some improvement in the U.S. economy. 

One question often discussed among economists and financial professionals is when the Fed will reverse course and increase the fed funds rate - with the goal of increasing interest rates. Most agree that signs of inflationary pressures will cause the FOMC to raise rates. The FOMC has made it clear that little inflationary pressure currently exists. Resource utilization is low and resource prices are stable if not decreasing. 

Energy prices may be the wide card, as oil prices have recently increased. If energy demand is a result of growth, the FOMC may anticipate more broad inflationary pressures. If other prices do not follow energy, the FOMC may not see the need to raise rates. Watch energy prices and the overall rate of inflation (CPI-U) in the coming months.

Is this FOMC statement good news or not?

ASSESSMENT ACTIVITY

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

 

  1. What is the purpose of the FOMC's target for the 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 that lists National Economic Indicators and additional links to the current data for each indicator.