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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 December 13, 2011, press release by the Federal Open Market Committee on the current Federal Reserve monetary policy actions and goals.

To learn more about the Federal Open Market Committee, its membership, meeting schedule, and responsibilities, go to: www.federalreserve.gov/monetarypolicy/fomc.htm.

TASK

  • Explain the meaning of the December 13, 2011, 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.
  • Identify the current actions taken by the Federal Reserve to achieve its monetary policy goals.
  • Explain the intended effects of open market operations.

PROCESS

December, 2011, marks three significant anniversaries related to the current U.S. business cycle.

  • In December, 2007, the most recent U.S. recession began.  The recession ended in June, 2009, but the business cycle trough was not identified until September, 2010.
  • On December 1, 2008, The National Bureau of Economic Research (NBER) declared that the U.S. economy reached a peak in the business cycle in December, 2007, and the most recent recession began. This announcement was made a full year after the recession began.
  • At its December 8, 2008, meeting, the Federal Open Market Committee established a new target for the federal funds rate, at a range of 0 to 1/4 percent.  This historically low fed funds rate target has been maintained at this level to this date.

 

What did the FOMC have to say, three years after pushing it's primary tool to reduce interest rates and stimulate credit markets - the federal funds rate - to it's low limit?

The Federal Reserve's Monetary Policy Goals

Remember, the national monetary policy goals of the Federal Reserve, as established by the federal Employment Act of 1946, are to "promote maximum employment, production, and purchasing power."

In other words, Fed and other government agencies should adopt policies to:

  • Create jobs - reduce the unemployment rate and increase employment.
  • Increase output - improve the real GDP growth rate.
  • Maintain stable purchasing power - keep the CPI increase at a low level.


Students: Read more about the Employment Act of 1946.  Link: research.stlouisfed.org/publications/review/article/2977

Note: The Business Cycle Dating Committee of the National Bureau of Economic Research is charged with identifying the peaks (beginning of a recessions) and the troughs (end of a recession) of the business cycles.  For more information, go to: www.nber.org/cycles/main.html

"Monetary Policy" Statement

Federal Open Market Committee
Released: December 13, 2011

"Information received since the Federal Open Market Committee met in November suggests that the economy has been expanding moderately, notwithstanding some apparent slowing in global growth. While indicators point to some improvement in overall labor market conditions, the unemployment rate remains elevated. Household spending has continued to advance, but business fixed investment appears to be increasing less rapidly and the housing sector remains depressed. Inflation has moderated since earlier in the year, and longer-term inflation expectations have remained stable."

The typical monetary policy statement begins with an observation about the recent health or the growth trend of the economy. In this case, it was a moderate expansion - consistent with recent real GDP growth and employment increases.

"Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee continues to expect a moderate pace of economic growth over coming quarters and consequently anticipates that the unemployment rate will decline only gradually toward levels that the Committee judges to be consistent with its dual mandate. Strains in global financial markets continue to pose significant downside risks to the economic outlook. The Committee also anticipates that inflation will settle, over coming quarters, at levels at or below those consistent with the Committee’s dual mandate. However, the Committee will continue to pay close attention to the evolution of inflation and inflation expectations."

Recent statements have referred to the Fed's mandate as explained in the beginning of this lesson - growth, stable prices and full employment.  The result of this meeting is no substantive policy change, with the Fed anticipating gradual improvement, despite the possibility of problems in global financial markets.  As with other recent statements, there was a mention of possible inflation in the longer  term.

Students:  Have you noticed any signs of inflation. Remember, gasoline prices tend to be more volatile - recently having increased and decreased almost monthly.  This may not be a sign of true inflation - an increase in the general price level.

"To support a stronger economic recovery and to help ensure that inflation, over time, is at levels consistent with the dual mandate, the Committee decided today to continue its program to extend the average maturity of its holdings of securities as announced in September. The Committee is maintaining its existing policies of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate."

No change in the additional Fed policies adopted at recent meetings extend the average maturity of its securities, improve bank liquidity, and encourage lending.  The Fed website explains: "Under the maturity extension program, the Federal Reserve intends to sell $400 billion of shorter-term Treasury securities by the end of June 2012 and use the proceeds to buy longer-term Treasury securities. This will extend the average maturity of the securities in the Federal Reserve’s portfolio."

"By reducing the supply of longer-term Treasury securities in the market, this action should put downward pressure on longer-term interest rates, including rates on financial assets that investors consider to be close substitutes for longer-term Treasury securities. The reduction in longer-term interest rates, in turn, will contribute to a broad easing in financial market conditions that will provide additional stimulus to support the economic recovery." www.federalreserve.gov/monetarypolicy/maturityextensionprogram.htm

"The Committee also decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013."

The federal funds rate target will remain at 0 to 1/4 percent as long as current economic conditions remain and inflation is not anticipated.  Remember, the FOMC's target rate of 0 to 1/4 percent has been in effect since 2008.  See Figure 1, below.

The low federal funds rate is intended to reduce the costs for depository institutions/member banks that borrow funds from other banks overnight to meet their reserve requirements. 

"The Committee will continue to assess the economic outlook in light of incoming information and is prepared to employ its tools to promote a stronger economic recovery in a context of price stability."

Is this good news or bad news?  Are the slightly lower (6.8 percent) unemployment rate in November and 2 percent real GDP growth in Q3 of 2011 signs of the improved health of the U.S. economy?   Figure 1, below, shows the recent history of the federal funds rate target.

figure 1

Students: Compare Figure 1, the fed funds rate targets, to Figures 2, 3, and 4 - the unemployment rate, real GDP growth rate, and productivity.  Are they related over time? 

The Federal Reserve uses monetary policy actions, such as open market operations - the buying and selling of government securities - to increase or decrease the money supply and bank lending activities to achieve the monetary policy goals of the Employment Act of 1946.  In a time of high unemployment and slow growth, an "accommodative" policy of low interest rates is intended to stimulate output and employment. In a time of high inflation, more restrictive policies - higher interest rates - may be used to slow economic activity.

How does the history of the federal funds rate relate to other recent economic data?

The Unemployment Rate

Figure 2, below, shows the recent history of the U.S. unemployment rate, reaching a recent low of 8.6 percent in November, 2011, after an extended period over 9 percent.

figure 2

Students: How does the level of the fed funds rate target relate to the recent levels of unemployment? 

U.S. Real GDP Growth

Figure 3, below, shows the recent history of the U.S. real gross domestic product growth rate. Note the cycles that are similar to the unemployment rate changes over time.

Figure 3

Students: How does the level of the fed funds rate target relate to the recent levels of real GDP growth/decline? 

Productivity

How can U.S. output be increasing and yet the unemployment rate remains high?  There are many factors influencing the growth and unemployment rates (size of the labor force, number marginal workers, etc.), but one key factor in the past year has been a significant increase in the rate of labor productivity - the amount of output per hour worked.

Look at the annual rates of productivity increases in recent years, below.    The BLS reported in November 30, 2011 that U.S. labor productivity increased at an annual rate of 2.3 percent in Q3 of 2011.

Figure 4: U.S. Annual Labor Productivity Change
Year Labor Productivity
Rate Change
2005 1.6%
2006 0.9%
2007 1.5%
2008 0.6%
2009 2.3%
2010 4.1%
2011 Q3 2.3%

 

Productivity and Costs, Third Quarter 2011, released November 30, 2011: www.bls.gov/news.release/prod2.nr0.htm

"Productivity rose 2.3 percent in the nonfarm business sector in the third quarter of 2011; unit labor costs decreased 2.5 percent (seasonally adjusted annual rates). In manufacturing, productivity grew 5.0 percent and unit labor costs fell 5.1 percent."

Students: Is this a ''jobless recovery'?  The economy has grown recently without creating large numbers of jobs. Is this the result of improved productivity? Is this good or bad?]

International News

On Thursday, December 1, the European Central Bank (ECB) reduced its primary interest rate for the second time in recent months in order to stabilize the European banks and, possibly, prevent a recession. 

Weakness in European financial markets, largely as a result of sovereign debt and unstable banks, has negatively impacted U.S. markets, but the FOMC has not considered the European situation enough of a threat to take stronger domestic actions at this time, adopting the current policy, even though "Strains in global financial markets continue to pose significant downside risks to the economic outlook."

Students: Do you care about what happens in European economies?  If European banks have financial problems, it affects U.S. banks and U.S. investors.  The financial system is truly global?

CONCLUSION

Once again, the FOMC's statement began, "Information received since the Federal Open Market Committee met in November suggests that the economy has been expanding moderately, notwithstanding some apparent slowing in global growth. While indicators point to some improvement in overall labor market conditions, the unemployment rate remains elevated. Household spending has continued to advance, but business fixed investment appears to be increasing less rapidly and the housing sector remains depressed. Inflation has moderated since earlier in the year, and longer-term inflation expectations have remained stable."

What more can the Federal Reserve, Congress, the President, or other government agencies do to get the economy moving at a faster pace and create jobs for the over fourteen million people who remain unemployed in the United States?

The Fed has kept the fed funds rate target historically low, influencing other rates to remain low - mortgage rates, consumer loans, auto loans, etc.  The Fed is purchasing securities to provide additional financial market liquidity.  

Interest rates are not the issue.  Uncertainty about the future and, perhaps, caution about global conditions and to not make the same mistakes may be keeping banks from lending, businesses from hiring and, consumers from purchasing.  

The Fed's policy statement provides some hope of improvement in growth of output and employment.  The recession over, but the impact remains and true recovery is slow?

Congress and President Obama seem to have agreed on a package of corporate and individual tax cut extensions, unemployment compensation extensions, and further stimulus policies to weather the storm, but at a very high price to be paid in the future. 

What more can the Fed do?

ASSESSMENT ACTIVITY

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


 

EXTENSION ACTIVITY

The Federal Reserve Bank of Philadelphia has published a new online activity called The Case of the Gigantic $100,000 Bill.  

Thumbnail for version as of 20:29, 15 August 2007

In this lesson, students participate in a demonstration of the money creation process using a large $100,000 bill. Expansions of the money supply caused by successive deposits and loans are traced on the board so that students can observe the process. Students learn to calculate the upper bound of the money creation process using the simple money multiplier. 

Students:  You can use this lesson to better understand the money multiplier and how the Federal Reserve can "create" money or change the money supply through monetary policy actions.