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This lesson focuses on the April 25, 2012, press release by the Federal Reserve System's Federal Open Market Committee (FOMC) on the current Federal Reserve monetary policy actions and goals, and specifically, the federal funds rate target. 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

Central Banking System, Federal Reserve, Macroeconomic Indicators, Monetary Policy, Money Supply, Tools of the Federal Reserve

STUDENTS WILL

  • Explain the meaning of the April 25, 2012, 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.

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.

The FOMC has maintained the federal funds rate target 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 the long period low and sometimes negative real GDP growth, significant numbers of non-farm employment losses, and a very high unemployment rate.

This lesson focuses on the April 25, 2012, press release by the Federal Open Market Committee on the current Federal Reserve monetary policy actions and goals.

[Note to teacher: In the second semester of the 2011-2012 school year (January-May), there will be three 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.

NOTE:  When necessary, the FOMC holds unscheduled face-to-face or conference call meetings to make more timely policy decisions in response to unusual economic events or conditions.  The policy decisions made as a result of any of these unscheduled meetings will be included in the lesson on the next scheduled meeting.]

RESOURCES

Key Economic Indicators

as of April 27, 2012

Inflation

On a seasonally adjusted basis, the Consumer Price Index for All Urban Consumers rose 0.3 percent in March after rising 0.4 percent in February. The index for all items less food and energy rose 0.2 percent in March after increasing 0.1 percent in February.

Employment and Unemployment

Nonfarm payroll employment rose by 120,000 in March, and the unemployment rate was little changed at 8.2 percent. Employment rose in manufacturing, food services and drinking places, and health care, but was down in retail trade.

Real GDP

Real gross domestic product increased at an annual rate of 2.2 percent in the first quarter of 2012 (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 of 2011, real GDP increased 3.0 percent.

Federal Reserve

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.

PROCESS

First, a Quick Review of Recent Monetary Policy History

On December 1, 2008, the Business Cycle Dating Committee of the National Bureau of Economic Research (NBER) declared that the U.S. economy reached a peak in the business cycle in December, 2007, and a recession had begun.

At its December 8, 2008, meeting, the Federal Open Market Committee established the target for the federal funds rate at a range of 0 to 1/4 percent.  This historically low fed funds rate target was aimed directly stimulating the economy through lower interest rates.  The Fed has maintained at this low level for the federal funds rate to this time.

On September 20, 2010, the Business Cycle Dating Committee of the National Bureau of Economic Research determined that a trough in business activity occurred in the U.S. economy in June, 2009, and that the recession had ended.

After the "official" end of the recession, the FOMC's target for the federal funds rate has not changed.  Other strategies to improve banking system liquidity and stimulate economic growth and employment have been added to the Fed's tool box.

[Teacher Note:  Ask your students if they feel that the U.S. is still in a recession?  What evidence do they have?]

                                             . . . . . . . . . . . . . . . . . . . . .

What did the FOMC have to say, more than three years after pushing its primary tool down to a record low in order to reduce interest rates and stimulate credit markets?

Remember, the primary monetary policy goals of the Federal Reserve, as established by the Employment Act of 1946, are to "promote maximum employment, production, and purchasing power."  In other words, policies should create jobs, increase output, and keep the price level stable.

[Teacher Note:  For information about the Employment Act of 1946, see the Federal Reserve Bank of St.Louis online article, “The Employment Act of 1946: Some History Notes,” by C. J. Santoni (November, 1986).  ' ]

Federal Open Market Committee “Monetary Policy” Statement
Released: April 25, 201

Note:  Unless otherwise cited, quoted material in this lesson is from the FOMC's April 25, 2012, monetary policy press release.

The FOMC announced, "Information received since the Federal Open Market Committee met in March suggests that the economy has been expanding moderately."

Teacher Note:  Ask your students: What does "expanding moderately" mean?  A dictionary defines "moderately" in this context as, "a: tending toward the mean or average amount or dimension;  b: having average or less than average quality : mediocre"

[Definition source: Merriam-Webster Online Dictionary, www.merriam-webster.com/dictionary/moderately?show=0&t=1335377457]

[Teacher Note: The consensus is that a real GDP growth rate is necessary to maintain full employment and to keep the economy stable.  In Q1 2012, U.S. real GDP grew at 2.2 percent.  Ask your students what can happen if the economy grows too slowly and the population continues to grow at a normal pace.]

More details from the April 25 announcement, "Labor market conditions have improved in recent months; the unemployment rate has declined but remains elevated. Household spending and business fixed investment have continued to advance. Despite some signs of improvement, the housing sector remains depressed. Inflation has picked up somewhat, mainly reflecting higher prices of crude oil and gasoline. However, longer-term inflation expectations have remained stable."

Inflationary pressures have not been strong enough for the FOMC to choose a higher federal funds rate target.  The trade-off between inflation and growth as potential policy targets has continued to lean toward growth.

The FOMC then commented on its progress toward achieving its macroeconomic goals - fostering maximum employment and maintaining price stability. 

"The unemployment rate remains elevated, and measures of underlying inflation continue to be somewhat low, relative to levels that the Committee judges to be consistent, over the longer run, with its dual mandate.  Increases in the prices of energy and other commodities have pushed up inflation in recent months."

What does the FOMC expect in the near future?

"Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee expects economic growth to remain moderate over coming quarters and then to pick up gradually. Consequently, the Committee anticipates that the unemployment rate will decline gradually toward levels that it judges to be consistent with its dual mandate. Strains in global financial markets continue to pose significant downside risks to the economic outlook. The increase in oil and gasoline prices earlier this year is expected to affect inflation only temporarily, and the Committee anticipates that subsequently inflation will run at or below the rate that it judges most consistent with its dual mandate."

The Fed will continue its "Large Scale Asset Purchases" program to use its balance sheet to improve the stability of the banking system and encourage banks to make loans.

"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."

As has been the case in the past few FOMC policy statements, one FOMC member, Jeffrey M Lacker, President of the Federal Reserve Bank of Richmond, voted against the statement because he does not like the idea that the Fed openly states that "economic conditions are likely to warrant exceptionally low levels of the federal funds rate through late 2014."

[Teacher Note: Is there any potential problem when the FOMC announces a specific time-frame for the current policy?  Is a less specific statement like "extended period" better?  Some argue that planners, investors, employers, etc., may respond more positively if they know more about future policy.  The specific date may reduce their uncertainty about the economy.  Do you agree or disagree?]

[Teacher Note:  The Federal Reserve Board of Governors has produced an online video program explaining  the "maturity extension," or "Large Scale Asset Purchases" monetary policy programs.[ www.federalreserve.gov/faqs/money_15070.htm ]

The FOMC federal funds rate action was 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."

What Will the Fed Look For in the Future? 

When assessing the health of the economy and the impact of past, current an future monetary policy actions, the FOMC will look closely at GDP growth, employment/unemployment, and other economic data.

Figure 1, below, shows the recent history of growth rates of U.S. real gross domestic product (real GDP).

figure 1

[Teacher Note: Is a 2.2 percent real GDP growth rate enough?]

Figure 2, below, shows the recent history of monthly U.S. unemployment rates.

figure 2

[Teacher Note:  Ask your students: If the U.S. unemployment rate remains as high as 7-8 percent, how will this potentially impact consumers and producers?] 

U.S. output is increasing, although at a slower rate than in the previous quarter (Q4 2011).  The U.S. unemployment rate continues to remain very high.  Look again at Figures 1 and 2.  Can you see the time period of the recession, December, 2007 through June, 2009?

The FOMC has kept the federal funds rate target at a very low level of 0 to .25 percent during the recession and to the present time, but the economy continues to recover very slowly.  Thus, the Fed continues a low interest rate policy that "accommodates" growth.  QE2 (the second round of quantitative easing), purchases of almost $800 billion in securities, intended to provide more market liquidity has officially ended, but continued policies to strengthen the banking system and promote growth continue.

In the past year, the Fed has enacted policies to purchase shorter term securities ad to lengthen the maturity of the Fed's portfolio.  The "Maturity Extension Program and Reinvestment Policy " program is ultimately intended to increase bank lending.

Is there a threat of inflation?  Take a look at the recent history of changes in the price level, as measured by the CPI-U, Figure 3, below.   The majority of the increases in the price level for the past two months has been energy and food prices.

figure 3

If you leave out the highly volatile energy (especially gasoline) prices over this time period, there has been very little inflation and occasionally some concern about the prospects for deflation.  Recently, many observers have feared a recurrence of inflation, driven by energy prices and continued government budget deficits.

[Teacher Note: Ask your students: Are you worried about inflation?  How have higher gasoline prices affected you and your family?]

[Teacher Note:  See the most recent EconEdLink lessons on the consumer price index, real GDP growth, and unemployment and employment for more detail on these macroeconomic measurements.  EconEdLink.]

Recent History of the Federal Funds Rate

At it's April 25, 2012, meeting the FOMC decided to keep the target for the federal funds rate at the same level that was first established in December, 2008.  Figure 4, below, shows the history of the federal funds rate from 1990 to the present.  Note the periodic increases and decreases, as the FOMC has sought to influence interest rates to rise and fall in order to reduce inflationary pressures, stimulate growth, or just to keep the price level stable.

figure 4

[Note to teacher: Students can read the FOMC policy statements over the past couple of years to track the beginning and progress of the current recession.  They may note the slight
changes in the statements that signal future direction. 
http://www.federalreserve.gov/monetarypolicy/fomccalendars.htm ]

What Are the Monetary Options?

What can the Fed do with its traditional tools to stabilize the economy?

Stimulatory Policy Actions - usually aimed at promoting economic growth:

   • Buy securities
   • Lower the discount rate
   • Lower bank reserve requirements

Contractionary Policy Actions - usually aimed at reducing inflation:

   • Sell securities
   • Raise the discount rate
   • Increase bank reserve requirements

How would each of the above policy tools (actions) impact the economy?

[Teacher Note:  The Federal Reserve Bank of Philadelphia has published an online lesson, "Monetary Policy."  Description: "Working in groups, students develop an understanding of monetary policy. Students learn about the indicators the Fed uses to determine what changes, if any, should be made to the course of monetary policy."  Link: www.federalreserveeducation.org/resources/detail.cfm?r_id=53368c4c%2Dc844%2D43c7%2Da904%2D7b92bbd15619 ]

CONCLUSION

This FOMC monetary policy announcement began with a quick assessment of current U.S. economic conditions. "Information received since the Federal Open Market Committee met in March suggests that the economy has been expanding moderately.  Labor market conditions have improved in recent months; the unemployment rate has declined but remains elevated."

The previous FOMC statement released in March, began, "the economic recovery is proceeding at a moderate pace and overall conditions in the labor market are improving gradually."

The beginning of the April 25 statement was a bit more specific, but still cautious.  The rate of U.S. real GDP growth has slowed and the unemployment rate remains at 8.2 percent.  Job growth in March, 2012, was much slower than the previous several months.

The current monetary policy continues to be "accommodative."  Low interest rates and other  policies to encourage lending and investment are focused directly on the Fed's goals to promote economic growth and full employment.

The FOMC federal funds rate action was 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."

The FOMC's statements in 2011 suggested that the fed funds rate target would remain low for an "extended period."   Recent FOMC statements have more clearly described their long-term policy as "at least through late 2014."  Many have interpreted this to mean that  the FOMC wants to provide some policy stability to the benefit of planners, investors, lenders and borrowers.  Stable policies can reduce the risk of decision-making.

In his press conference after the news release, Fed Chairman Ben S. Bernanke reiterated that, "Each of these policy actions is intended to foster accommodative financial conditions that support the economic recovery in a context of price stability."   Bernanke ended his formal remarks with this caveat. "Finally, the Committee took no new decisions regarding the Federal Reserve's balance sheet today, but we remain prepared to adjust our securities holdings as appropriate to promote a stronger economic recovery in the context of price stability."

Bernanke, recognizing the may potential threats tot he U.S. and global recovery, reaffirmed that the Fed is ready to act if economic growth slows or if the threat of inflation worsens.

ASSESSMENT ACTIVITY

Have your students click start to complete this quiz on the April 25, 2012, FOMC monetary policy statement.

Multiple Response Questions

1)  What organization(s) borrows money at the federal funds interest rate?

a)  Federal Reserve banks
b)  depository institutions/member banks [CORRECT]
c)  the federal government

[The federal funds rate is the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight. Source: About the FOMC]

2)  In its April 25, 2012, announcement, how did the FOMC characterize the pace of the U.S. economic recovery?

a)  slow
b)  moderate [CORRECT]
c)  strong

[See the FOMC announcement: "Information received since the Federal Open Market Committee met in March suggests that the economy has been expanding moderately."]

3) What organization identifies the U.S. business cycles and recessions?

a) United States Treasury
b) National Bureau of Economic Research [CORRECT]
c) Federal Open Market Committee

[The Business Cycle Dating Committee of the National Bureau of Economic Research met at the organization's headquarters in Cambridge, Massachusetts, on April 8, 2010. The committee reviewed the most recent data for all indicators relevant to the determination of a possible date of the trough in economic activity marking the end of the recession that began in December 2007. The trough date would identify the end of contraction and the beginning of expansion.]

4)  What is the status of the Federal Reserve's strategy to purchase long-term treasury securities in order to provide greater bank liquidity and stabilize financial markets?

a)  The program has not worked and has been abandoned.
b)  The Fed will continue to purchase securities as scheduled. [CORRECT]
c)  The program will be expanded to purchase more securities than planned.

[See the FOMC announcement: The Committee also decided to continue its program to extend the average maturity of its holdings of securities as announced in September."]

5)  What is the current target range, as of April 27, 2011, for the federal funds rate?

a)  0 - 1/4 percent [CORRECT]
b)  1/4 - 1/2 percent
c)  1/2 - 3/4 percent

[See the FOMC announcement: "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. ]

6)  What decision did the FOMC announce on April 27, 2011, regarding the target for the federal funds rate target?

a) increase the fed funds rate target
b) decrease the fed funds rate target
c) no change in the fed funds rate target [CORRECT]

[See the FOMC announcement: "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."]

7)  What is the direct intent of open market operations?

a)  implementing FOMC monetary policy goals [CORRECT]
b)  establishing a prime interest rate for banks
c)  regulating member banks lending practices

[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]

8) How can the Federal Reserve increase the banks' ability to make loans?
a) purchase securities [CORRECT]
b) sell securities

[By purchasing securities, the Fed gives the banks more cash reserves to lmake loans.]

 

Essay Question:

1.  What is the purpose of the FOMC's target for the federal funds rate?

[The FOMC sets the target federal funds rate in order to influence interest rates and to expand or contract the money supply. It is the "target"' or the goal of the Federal Reserve. To achieve the goal, the Federal Reserve Bank of New York Trading Desk will purchase or sell securities in order to influence bank reserves and lending. This, in turn, will stimulate or contract the money supply and economic activity.]

EXTENSION ACTIVITY

Idea #1.  The Federal Reserve Bank of Philadelphia has published an online activity called "The Case of the Gigantic $100,000 Bill."   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. 

Go to: The Case of the Gigantic $100,000 Bill.

Idea #2.  The Federal Reserve Bank of San Francisco publishes a website called "The Economy: Crisis and Response," with information about the Fed's policies during the recession and banking crisis. 

Description: "The financial market turmoil that began in 2007 led to a severe global economic downturn. The causes of the crisis, the effects on global financial markets, and the spillover to the economy are examined here."

Go to: The Economy: Crisis and Response