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 zero to 1/4 percent since its December 16, 2008 meeting. The fed funds rate has been kept at this historically low level due to a long period of low and often negative real GDP growth, record numbers of non-farm employment losses, and a persistently high unemployment rate.
This lesson focuses on the March 15, 2011, press release by the Federal Open Market Committee on the current Federal Reserve monetary policy actions and goals.
- Explain the meaning of the March 15, 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.
The Federal Open Market Committee (FOMC) of the Federal Reserve System (Fed) has maintained its target for the federal funds rate at a range of zero to 1/4 percent since December 16, 2008. This historically low target was intended at the time to provide the liquidity and low interest rates to stimulate the economy at the beginning of the recession and during the banking crisis. The federal funds rate is the interest rate at which member bank loan reserves to other member banks overnight so that banks can meet their reserve requirements.
Since that time, the FOMC has kept the federal funds rate very low and has provided additional stabilization and stimulus through a variety of programs intended to improve the balance sheets of banks and liquidity in credit markets. The Fed has purchased hundreds of billions of dollars of securities through "quantitative easing" programs referred to as "QE." Later, a second round of purchases was enacted, commonly referred to as "QE2." The so-called "operation twist "began in September, 2011. By selling shorter-term bonds and purchasing longer-term bonds, the Fed hoped to drive down the interest rate on 10-year bonds.
Does this sound like a reasonable responsibility for the Federal Reserve?
At its most recent meeting, the FOMC reiterated its commitment to economic stimulus.
Board of Governors of the Federal Reserve System
Federal Open Market Committee
March 13, 2012
"Information received since the Federal Open Market Committee met in January suggests that the economy has been expanding moderately. Labor market conditions have improved further; the unemployment rate has declined notably in recent months but remains elevated. Household spending and business fixed investment have continued to advance. The housing sector remains depressed. Inflation has been subdued in recent months, although prices of crude oil and gasoline have increased lately. Longer-term inflation expectations have remained stable."
The statement began with FOMC's broad view of the U.S. economy, referring to the events and changes since the last FOMC meeting. In this case, a more optimistic view than in past announcements, using the phrase "expanding moderately."
The next section of the statement reaffirmed the FOMC's commitment to its Congressional mandate, to maintain a stable price level, economic growth, and full employment. This mandate was first established by a federal law, the "Employment Act of 1946."
Want to read about the Employment Act of 1946? Go to: research.stlouisfed.org/publications/review/86/11/Employment_Nov1986.pdf
"Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee expects moderate economic growth over coming quarters and consequently anticipates that the unemployment rate will decline gradually toward levels that the Committee judges to be consistent with its dual mandate. Strains in global financial markets have eased, though they continue to pose significant downside risks to the economic outlook. The recent increase in oil and gasoline prices will push up inflation temporarily, but the Committee anticipates that subsequently inflation will run at or below the rate that it judges most consistent with its dual mandate."
As always, the FOMC made it clear that it was ready to counter any inflationary pressures. In this case, the FOMC recognized the recent high energy and food prices, but did not expect long-term and serious impact in the shorter term.
If the FOMC members sense that inflation is a serious threat, what should they do? Remember, a rise in interest rates may slow GDP and employment growth.
What will the Fed do?
"To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee expects to maintain a highly accommodative stance for monetary policy. In particular, the Committee decided today 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 late 2014."
There was no new policy action on the federal funds rate target - maintaining the low rates of the past two years. Again, the recent increases in energy and food prices did not impact Fed policy.
"The Committee also decided 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 to promote a stronger economic recovery in a context of price stability."
What should the Fed do. Or, what else can they do, since the federal funds rate is so low? Can the Fed directly help to create jobs? Should the Fed have the power to force banks to make more loans that create jobs?
The Federal Funds Rate
Targeting the federal funds rate has been the primary policy of the FOMC in recent years. 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.
Banks use their reserves to generate loans. Loans facilitate investment and consumption. The lower the cost of the loans, the more investment and consumption - in theory. In this recovery, low interest rates have not been enough to generate jobs and growth, so the Fed has turned to more direct actions.
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.
In this recovery, low interest rates have not been enough to generate sufficient jobs and growth, so the Fed has turned to more direct actions. In recent months, job growth has improved and output is increasing. Is "stay the course" the best policy?
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.
Do you see the connections between the historical "business cycles" and the movements of the federal funds rate target?
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 currently at such a low level (0 to 1/4 percent) 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. 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 change the discount rate as it establishes a target for the federal funds rate.
How important is it that the Federal Reserve has independent power to implement monetary policies to maintain a stable price level, promote employment growth, and stimulate growth in the economy?
Was there more FOMC optimism in March 2012?
In recent times, each FOMC statement has begun with the same line, “Information received since the Federal Open Market Committee met in (referencing the date of the previous meeting)." This opening provides the basic rationale for the meeting decision. The March 13, 2012, statement began, “Information received since the Federal Open Market Committee met in January suggests that the economy has been expanding moderately. Labor market conditions have improved further; the unemployment rate has declined notably in recent months but remains elevated.” This was, perhaps, the most optimistic sounding introduction in recent times.
Here’s a recent history of this key FOMC language:
- April 28, 2010: “economic activity has continued to strengthen and that the labor market is beginning to improve.”
- June 23, 2010: “the economic recovery is proceeding and that the labor market is improving gradually.”
- August 10, 2010: “the pace of recovery in output and employment has slowed in recent months.”
- September 21, 2010: “the pace of recovery in output and employment has slowed in recent months.”
- November 3, 2010: “the pace of recovery in output and employment continues to be slow.”
- December 14, 2010: “the economic recovery is continuing, though at a rate that has been insufficient to bring down unemployment.”
- January 26, 2011: “the economic recovery is continuing, though at a rate that has been insufficient to bring about a significant improvement in labor market conditions.”
- March 15, 2011: “the economic recovery is on a firmer footing, and overall conditions in the labor market appear to be improving gradually.”
- April 27, 2011: "economic recovery is proceeding at a moderate pace and overall conditions in the labor market are improving gradually."
- June 22, 2011: "at a moderate pace, though somewhat more slowly than the Committee had expected.."
- August 9, 2011: "economic growth so far this year has been considerably slower than the Committee had expected."
- September 21, 2011: "economic growth remains slow."
- November 2, 2011: "economic growth strengthened somewhat in the third quarter, reflecting in part a reversal of the temporary factors that had weighed on growth earlier in the year."
- December 13, 2011: "the economy has been expanding moderately."
- January 25, 2012: "economy has been expanding moderately, notwithstanding some slowing in global growth."
- March 13, 2012 (THIS MEETING): "economy has been expanding moderately. Labor market conditions have improved."
Notice how the language changed slightly from meeting to meeting - mostly a vague assessment. The language from the last few meetings has focused on "moderate" growth.
What do you think the FOMC might have meant by terms like "on a firmer footing" or "moderate growth,"? Can you identify some of the economic data the FOMC might have used to make these statements?
The Fed and Banking Regulation – the “Stress Tests”
One of the Federal Reserve’s statutory responsibilities is to regulate banks in ways that help to ensure the stability of individual banks and the entire banking system.
On March 13, 2012, the Federal Reserve announced the results of the latest round Comprehensive Capital Analysis and Reviews (CCAR ) or “stress tests.” The stress test process was designed during the 2008-2009 financial crisis to determine if the major banks will be able to meet “capital adequacy” requirements “despite large projected losses in an extremely adverse hypothetical economic scenario.” The tests determine if the banks would have sufficient remaining capital to continue to meet their obligations and continue lending.
In this test, the scenario simulated a major financial crisis, far worse than the 2008-2009 conditions, including a 13 percent unemployment rate, a 50 percent drop in equity prices, and a 21 percent decline in housing prices. 15 of the 19 large bank holding companies passed the “test,’ meaning that they would maintain their capital ratios at above minimum under such an extreme economic conditions. Those banks that did not meet the minimum levels as a result of the tests must adjust their positions and planning to meet the requirements.
The Fed’s explanation for the tests was that, “Strong capital levels are critical to ensuring that banking organizations have the ability to lend and to continue to meet their financial obligations, even in times of economic difficulty.” By requiring the banks to maintain solvency even during extreme economic conditions, the Fed can better ensure the solvency of the individual banks and the entire system without more direct government intervention.
- Is this an appropriate regulatory role for the Federal Reserve?
The March 13, 2012, FOMC monetary policy statement confirmed what many economists, analysts and news commentators expected - no change in the federal funds rate target and continuation of programs to improove n=bank balance sheets and liquidity.
Again, the FOMC recognized some inflationary pressures, but not enough to warrant any monetary tightening. The bottom line: continue the existing policies and keep an eye out for change.
Energy prices may be the wide card, as oil prices have recently increased. If energy demand and supply disruptions continue, 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?
Students: Click the start button below to complete this interactive quiz about the March 13, 2012, FOMC announcement.
Next, answer the questions below on the interactive notepad.
The Federal Reserve has published an Internet-based educational 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.
- The above link will take you to the section on "Monetary Policy." Review the "Basics of Monetary Policy."
- Click on "How does the Fed create money?" to learn how Fed actions can influence the money supply.
- 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 a variety of economic data sources (www.forexhound.com/article/Central_Banks/Fed_Background/Economic_Indicators_By_the_Numbers/69850 , www.federalreserveeducation.org/resources/economic_indicators/ ) and additional links to the current data for each indicator.
To find information about your Federal Reserve System district reserve bank, go to: www.federalreserveeducation.org/about-the-fed/ and click on your region on the map.
[Note to Teachers: Have your students look at the information about their region's Federal Reserve Bank.]