Return

This lesson focuses on the September 13, 2012, press release by the Federal Reserve System's Federal Open Market Committee (FOMC) on the current Federal Reserve monetary policy actions and goals. Specifically, the lesson reports the target rate for the federal funds rate. 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, Discount Rate, Federal Reserve, Federal Reserve Structure, Macroeconomic Indicators, Monetary Policy, Open Market Operations, Recession, Reserve Requirements

STUDENTS WILL

  • Explain the significance and possible consequences of the September 13, 2012, Federal Reserve 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 November 10, 2014

Inflation

The Consumer Price Index for All Urban Consumers increased 0.1 percent in October on a seasonally adjusted basis. The core inflation rate increased the same amount. For the previous 12 months, the index increased 1.7%, the same rate as reported in the September report.

Employment and Unemployment

According to the October report of the Bureau of Labor Statistics, the unemployment rate fell from 5.9% to 5.8%, and the number of individuals unemployed also decreased. Total nonfarm employment rose by 214,000 in October. Employment gains were concentrated in retail trade, food services and health care.

Real GDP

The advance estimate for real GDP growth in the third quarter of 2014 was 3.5%, a decrease from the revised second quarter growth of 4.6%. Inventory investment reduced third quarter growth, while it added to second quarter growth. In addition, consumer spending increased at a lower rate in the third quarter, compared to the second. Finally, business investment increased in the third quarter, but at a lower rate than in the second quarter.

Federal Reserve

The FOMC believes that the labor market has shown considerable improvement and the risks of inflation rising above its 2% target are low. Therefore, the Federal Reserve announced plans to end its purchase of financial assets. In addition, the federal funds rate will remain at its current low level. However, the FOMC has signaled its willingness to increase the federal funds rate if inflation shows signs of rising above the 2% target.

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 a long period of low and sometimes negative real GDP growth and a persistently high unemployment rate.

This lesson focuses on the September 13, 2012, press release by the Federal Open Market Committee on the current Federal Reserve monetary policy actions and goals, followng the FOMC's regularly scheduled September 12-13 meeting.

[Note: In the first semester of the 2012-2013 school year (September-December), there will be three Focus on Economic Data lessons about 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 about the scheduled October 23-24 and December 11-12, 2012, FOMC meetings 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.

On occasion, 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 about the next scheduled meeting announcement.]

RESOURCES


Key Economic Indicators

as of September 14, 2012

Inflation

On a seasonally adjusted basis, the Consumer Price Index for All Urban Consumers increased 0.6 percent in August after being unchanged in July. The index for all items less food and energy rose 0.1 percent in August, the same increase as in July.

Employment and Unemployment

Total nonfarm payroll employment rose by 96,000 in August, and the unemployment rate edged down to 8.1 percent. Employment increased in food services and drinking places, professional and technical services, and health care.

Real GDP

Real gross domestic product -- the output of goods and services produced by labor and property located in the United States -- increased at an annual rate of 1.7 percent in the second quarter of 2012 (that is, from the first quarter to the second quarter), according to the "second" estimate released by the Bureau of Economic Analysis. In the first quarter, real GDP increased 2.0 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 economic recovery strengthens. In particular, the Committee also decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015.

PROCESS

U.S. Monetary Policy - September 12, 2012

The purpose of the Federal Reserve System's Federal Open Market Committee (FOMC) is to undertake monetary policy actions to "influence the availability and cost of money and credit to help promote national economic goals."  The FOMC meets approximately every six weeks to review and recommend monetary policy goals and actions.

The nation's overall macroeconomic goals, as established by the Employment Act of 1946 (Public Law 79-304, February 20, 1946), are to "promote maximum employment, production, and purchasing power."  The Fed's monetary policies are intended to help achieve these goals.  The Federal Reserve Act of 1913 had previously given the Federal Reserve responsibility for establishing monetary policy. 

In 1978, the Full Employment and Balanced Growth Act (also known as the Humphrey–Hawkins Full Employment Act), amended the 1946 law, after unemployment and inflation levels began to rise. The 1978 law called for a more specific macroeconomic goal - full employment.

[Teacher Note:  For information about the Employment Act of 1946, see: Santoni, G.J., "The Employment Act of 1946: Some History Notes," Federal Reserve Bank of St. Louis, November 1986. URL: ' ]

[Teacher Note:  Ask your students what they think of these national economic goals -   promote maximum employment, production, and purchasing power  .  What do they mean? Should there be other national macroeconomic goals?  For more information about the purchasing power and growth goals, see the recent EconEdLink "Focus on Economics Data" lessons on the CPI, real GDP growth and employment.]

[Teacher Note: Ask:  Do you think we can have full employment, growth and low inflation at the same time?  Suggest that growth and full employment tend to put pressure on commodity and product prices.  There is commonly a trade-off between the strategies to achieve these goals. Expansionary policies can result in inflkationary pressures. Policies to fight inflation can result in slower growth and unemployment.]

Take a look at the FOMC's September 13, 2012, monetary policy announcement for a better understanding of how the Federal Reserve's actions impact the current health and future prospects for the U.S. economy

[Teacher Note: An overview of the Federal Reserve and monetary policy is included in this lesson after comments on the current FOMC monetary policy actions.  For details about the FOMC, go to: www.federalreserve.gov/monetarypolicy/fomc.htm .]

Federal Open Market Committee Monetary Policy Press Release
Released: September 13, 2012

"Information received since the Federal Open Market Committee met in August suggests that economic activity has continued to expand at a moderate pace in recent months. Growth in employment has been slow, and the unemployment rate remains elevated. Household spending has continued to advance, but growth in business fixed investment appears to have slowed. The housing sector has shown some further signs of improvement, albeit from a depressed level. Inflation has been subdued, although the prices of some key commodities have increased recently. Longer-term inflation expectations have remained stable."

NOTE: Unless otherwise cited, all quoted materials in this lesson are from the September 13, 2012, FOMC announcement.

The first paragraph of many recent FOMC announcements have begun, "Information received since the Federal Open Market Committee met in..."  Since each announcement may signal a continuation or change in policy since the last meeting, any economic changes since that meeting are the focus of the FOMC's policy decision. In this case, the FOMC statement began with a positive outlook for the U.S. economic growth, but a less positive outlook for employment.  "...economic activity has continued to expand at a moderate pace in recent months. Growth in employment has been slow, and the unemployment rate remains elevated."

[Teacher Note:  The FOMC announcement mentions some specific factors influencing its decision.  In this case, some mixed signals, "the unemployment rate remains elevated. Household spending has continued to advance, but growth in business fixed investment appears to have slowed."  Ask your students to suggest how these may have influenced the FOMC's decision.]

Next, the FOMC provided a rational for its policy decision, based on its Congressional mandate.  The focus was on slow employment growth and lack of inflationary pressure.

  • "Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee is concerned that, without further policy accommodation, economic growth might not be strong enough to generate sustained improvement in labor market conditions. Furthermore, strains in global financial markets continue to pose significant downside risks to the economic outlook. The Committee also anticipates that inflation over the medium term likely would run at or below its 2 percent objective."

What is the FOMC's current policy priority?

  • "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 agreed today to increase policy accommodation by purchasing additional agency mortgage-backed securities at a pace of $40 billion per month. The Committee also will continue through the end of the year its program to extend the average maturity of its holdings of securities as announced in June, and it is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities. These actions, which together will increase the Committee’s holdings of longer-term securities by about $85 billion each month through the end of the year, should put downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative."

The FOMC's priority is the economic recovery.  While continuing recent programs to extend the maturity of its security portfolio, they also pledged to purchase up to $40 billion in mortgage backed securities.  This strategy is intended to further reduce long-term interest rates and stimulate investment and growth. Growth should positively impact hiring and reduce unemployment. This was a departure form recent policy statements in that it more specifically focused on employment and an even longer term strategy a New York Times article headline referred to as a "Forceful Move."  [Appelbaum, Binyamon. "Fed Ties New Aid to Jobs Recovery in Forceful Move," The New York Times (September 14, 2012), page 1.]

The FOMC extended its projection for the current low interest rate policy through mid-2015 and "until the economic recovery strengthens."

  • "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 economic recovery strengthens. In particular, the Committee also decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015."

In November, 2010, the Fed announced a plan to purchase $600 billion in securities in order to increase liquidity in financial markets and stimulate the economy.  Though this plan has critics, the Fed has stuck with the strategy.  This time, the FOMC reiterated that goal and added a significant program to purchase mortgage-backed securities to further boost the housing market.

The FOMC decision was not unanimous. One member was concerned about the very specific time frame of the policy statement.

  • "Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Dennis P. Lockhart; Sandra Pianalto; Jerome H. Powell; Sarah Bloom Raskin; Jeremy C. Stein; Daniel K. Tarullo; John C. Williams; and Janet L. Yellen. Voting against the action was Jeffrey M. Lacker, who opposed additional asset purchases and preferred to omit the description of the time period over which exceptionally low levels for the federal funds rate are likely to be warranted."

[Teacher Note:  Students can read the FOMC announcement from the FOMC webpage  . It may be more interesting and effective to read it from the original source  Note the careful use of language by the FOMC.  In several weeks, the minutes of the September 12-13 meeting will be released.  The minutes often explain the points of agreement and disagreement among the committee. Link: http://www.federalreserve.gov/newsevents/press/monetary/20110126a.htm

In summary, this announcement was very similar to those of the FOMC meetings over the past year and a half, since the end of the recession.   Keep interest rates low, provide greater liquidity, and keep an eye out for any changes in economic conditions, especially any signs of inflation. 

Recent FOMC announcements have been accompanied by a press conference by Ben Bernanke, the Fed chairman, who adds some details to the official announcement and answers questions.  In the future, the individual district banks will announce actions in their regions.

 

Introduction to The Federal Reserve System, the FOMC, and Monetary Policy

The Federal Reserve System was created by Congress in 1913 "to provide the nation with a safer, more flexible, and more stable monetary and financial system." It is a federal system, composed of a central, governmental agency, the Board of Governors, in Washington, D.C., and twelve regional Federal Reserve Banks, located in major cities throughout the nation.

[Teacher Note: Much of the following is summarized from the Federal Reserve publication: "The Federal Reserve System: Purposes and Functions ," which is available online.  Unless specified as another source, the information is from this publication.]

The Federal Reserve’s duties fall into four general areas:

  1. Conducting the nation’s monetary policy by influencing monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates.
     
  2. Supervising and regulating banking institutions to ensure the safety and soundness of the nation’s banking and financial system and to protect the credit rights of consumers.  
     
  3. Maintaining the stability of the financial system and containing systemic risk that may arise in financial markets.
     
  4. Providing financial services to depository institutions, the U.S. government, and foreign official institutions, including playing a major role in operating the nation’s payments system.

[Teacher Note:  Review the four Federal Reserve duties mentioned above.  Note that monetary policy is just one duty.  The others include services that are provided by the district banks.  See the online version of "The Federal Reserve: Purposes & Functions" for more details.  Link: http://www.federalreserve.gov/pf/pf.htm ]

A Brief History of Central Banks

Most developed countries have a central bank whose functions are broadly similar to those of the Federal Reserve. The oldest, Sweden’s Riksbank, has existed since 1668 and the Bank of England since 1694. Napoleon I established the Banque de France in 1800, and the Bank of Canada began operations in 1935. The German Bundesbank was reestablished after World War II and is loosely modeled on the Federal Reserve. More recently, some functions of the Banque de France and the Bundesbank have been assumed by the European Central Bank, formed in 1998.

The Creation of the Federal Reserve System

During the nineteenth century and the beginning of the twentieth century, financial panics plagued the nation, leading to bank failures and business bankruptcies that severely disrupted the economy. The failure of the nation’s banking system to effectively provide funding to troubled depository institutions contributed significantly to the economy’s vulnerability to financial panics. After the crisis of 1907, Congress established a commission and institution that would help prevent and contain financial disruptions.

Congress passed the Federal Reserve Act in “to provide for the establishment of Federal reserve banks, to furnish an elastic currency, to afford means of re-discounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes.” President Woodrow Wilson signed the act into law on December 23, 1913.

The twelve regional Federal Reserve Banks and their Branches carry out a variety of System functions, including operating a nationwide payments system, distributing the nation’s currency and coin, supervising and regulating member banks and bank holding companies, and serving as banker for the U.S. Treasury. The twelve Reserve Banks are each responsible for a particular geographic area or district of the United States. Each Reserve District is identified by a number and a letter. Besides carrying out functions for the System as a whole, such as administering nationwide banking and credit policies, each Reserve Bank acts as a depository for the banks in its own District and fulfills other District responsibilities.

[Teacher Note:  Students should be able to identify the Federal Reserve District bank that serves their school's geographic area.  Federal Reserve System map .]

The Twelve Federal Reserve Districts

figure1

Who owns the Fed?

Though its name may sound like a government-run agency, the Federal Reserve System is an independent body, created by Congress and subject to audit by the Government Accountability Office(GAO). The twelve district banks are owned by the member banking institutions. The Federal Reserve Board members and Chairman are appointed by the President and confirmed by Congress.  Each district bank has its own board of directors.

The Federal Reserve's website explains:  "The Federal Reserve System fulfills its public mission as an independent entity within government.  It is not "owned" by anyone and is not a private, profit-making institution."

"As the nation's central bank, the Federal Reserve derives its authority from the Congress of the United States. It is considered an independent central bank because its monetary policy decisions do not have to be approved by the President or anyone else in the executive or legislative branches of government, it does not receive funding appropriated by the Congress, and the terms of the members of the Board of Governors span multiple presidential and congressional terms."

"However, the Federal Reserve is subject to oversight by the Congress, which often reviews the Federal Reserve's activities and can alter its responsibilities by statute. Therefore, the Federal Reserve can be more accurately described as "independent within the government" rather than "independent of government."

"The 12 regional Federal Reserve Banks, which were established by the Congress as the operating arms of the nation's central banking system, are organized similarly to private corporations--possibly leading to some confusion about "ownership." For example, the Reserve Banks issue shares of stock to member banks. However, owning Reserve Bank stock is quite different from owning stock in a private company. The Reserve Banks are not operated for profit, and ownership of a certain amount of stock is, by law, a condition of membership in the System. The stock may not be sold, traded, or pledged as security for a loan; dividends are, by law, 6 percent per year. "  Source: http://www.federalreserve.gov/faqs/about_14986.htm .

What if the Fed makes a profit?

In January, 2012, the Federal Reserve System announced that it was turning over $77 billion in profits to the U.S. Treasury, as it is required by law.  The profits were the return from the Fed's investment portfolio - treasury securities, mortgage-backed securities, other investments, and some income from services it provides to financial institutions. 

The Federal Reserve Board of Governors

The seven members of the Board of Governors are appointed by the President and confirmed by the Senate to serve 14-year terms of office. Members may serve only one full term, but a member who has been appointed to complete an unexpired term may be reappointed to a full term. The President designates, and the Senate confirms, two members of the Board to be Chairman and Vice Chairman of the Federal Reserve, for four-year terms. The current chairman of the Federal Reserve is Ben S. Bernanke, Ph.D. See Figure 2.

figure 2

The Federal Open Market Committee (FOMC)

An important component of the Federal Reserve System is the Federal Open Market Committee (FOMC), which is made up of the members of the Board of Governors, the president of the Federal Reserve Bank of New York, and presidents of four other Federal Reserve Banks, who serve on a rotating basis. The FOMC oversees open market operations, which is the main tool used by the Federal Reserve to influence money market conditions and the growth of money and credit. Traditionally, the Chairman of the Board of Governors serves as the Chairman of the FOMC. 

[Teacher note:  What do your students think is the rationale for the mix of voting members on the FOMC - seven FRB Governors, the NY Fed president and four other reserve bank presidents?  Some have a "national" view and others represent regional views. It is important that these perspectives all be represented and that economic power not be too concentrated  or too dispersed.]

From the Fed webpage: "The Federal Open Market Committee (FOMC) consists of twelve members--the seven members of the Board of Governors of the Federal Reserve System; the president of the Federal Reserve Bank of New York; and four of the remaining eleven Reserve Bank presidents, who serve one-year terms on a rotating basis. The rotating seats are filled from the following four groups of Banks, one Bank president from each group: Boston, Philadelphia, and Richmond; Cleveland and Chicago; Atlanta, St. Louis, and Dallas; and Minneapolis, Kansas City, and San Francisco. Nonvoting Reserve Bank presidents attend the meetings of the Committee, participate in the discussions, and contribute to the Committee's assessment of the economy and policy options."

Federal Reserve Policy Tools

The Federal Reserve implements monetary policy through its control over the federal funds rate, the rate at which depository institutions trade balances at the Federal Reserve. It exercises this control by influencing the demand for and supply of these balances through the following means:

  • Open market operations: the purchase or sale of securities, primarily U.S. Treasury securities, in the open market to influence the level of balances that depository institutions hold at the Federal Reserve Banks. Open market operations are used to meet the goal of the target federal funds rate. Open market operations are conducted by the Domestic Trading Desk at the Federal Reserve Bank of New York.  
  • Reserve requirements: requirements regarding the percentage of certain deposits that depository institutions must hold in reserve in the form of cash or in an account at a Federal Reserve Bank.  
  • Contractual clearing balances: an amount that a depository institution agrees to hold at its Federal Reserve Bank in addition to any required reserve balance.  
  • Discount window lending (discount rate): extensions of credit to depository institutions made through the primary, secondary, or seasonal lending programs.


By trading government securities, the New York Fed affects the federal funds rate, which is the interest rate at which depository institutions lend balances to each other overnight. The Federal Open Market Committee establishes the target rate for trading in the federal funds market. The target rate is currently set at a 0 to 1/4 percent range (since December, 2008.)

Figure 3, below, shows the recent history of the target federal funds rate through current period. Notice how the target rate has normally moved up and down in a cyclical pattern. This pattern of change is strongly correlated with the business cycles, generally increasing during expansionary periods and decreasing during contractions. The fed funds rate target has been set at 0 to 1/4 percent since December 2008.

figure 2

NOTE:  PUT THE "LIBOR" INFORMATION BELOW IN A BOX.

What About LIBOR?

You may have heard recently some controversy over “LIBOR” interest rates.  In the news, this may sound like LIBOR and the federal funds rate are the same.  Well, they are similar, in that they are loans form one bank to another, but they are not the same.

The federal funds rate is the interest rate at which banks (depository institutions) lend their excess reserve balances to other banks. Only U.S. banks participate in this system.  These loans are usually overnight in U.S. dollars.

The target federal funds rate is a target interest rate that is set by the FOMC for implementing U.S. monetary policies.  The effective federal funds rate is achieved by using open market operations through the Federal Reserve Bank of New York, trading U.S. Treasury and other federal agency securities.

LIBOR (London InterBank Offered Rate) is the average interest rate determined by a small group of large banks that participate in the London interbank money market.  One bank can borrow unsecured funds from other banks at this rate. These loans can be from overnight to one year, and can be in a variety of currencies.

LIBOR is calculated from prevailing interest rates between highly credit-worthy institutions.  It may or may not be used to derive business terms. It is not fixed beforehand and is not meant to be part of macroeconomic policy.

For more information about the U.S. Federal Reserve System and the Board of Governors of the Federal Reserve System

For more information about the FOMC, go to "About the FOMC "

How Monetary Policy Affects the Economy

The initial link in the chain between monetary policy and the economy is the market for balances held at the Federal Reserve Banks. Depository institutions have accounts at their Reserve Banks, and they actively trade balances held in these accounts in the federal funds market at an interest rate known as the federal funds rate. The Federal Reserve exercises considerable control over the federal funds rate through its influence over the supply of and demand for balances at the Reserve Banks.

The FOMC sets the federal funds rate at a level it believes will foster financial and monetary conditions consistent with achieving its monetary policy objectives, and it adjusts that target in line with evolving economic developments. A change in the federal funds rate, or even a change in expectations about the future level of the federal funds rate, can set off a chain of events that will affect other short-term interest rates, longer-term interest rates, the foreign exchange value of the dollar, and stock prices. In turn, changes in these variables will affect households’ and businesses’ spending decisions, thereby affecting growth in aggregate demand and the economy.

Short-term interest rates, such as those on Treasury bills and commercial paper, are affected not only by the current level of the federal funds rate but also by expectations about the overnight federal funds rate over the duration of the short-term contract. As a result, short-term interest rates could decline if the Federal Reserve surprised market participants with a reduction in the federal funds rate, or if unfolding events convinced participants that the Federal Reserve was going to be holding the federal funds rate lower than had been anticipated. Similarly, short-term interest rates would increase if the Federal Reserve surprised market participants by announcing an increase in the federal funds rate, or if some event prompted market participants to believe that the Federal Reserve was going to be holding the federal funds rate at higher levels than had been anticipated.

Expansionary monetary policy actions: Decrease interest rates

  • Reduce the target fed funds rate
  • Open market operations: buy securities
  • Reduce reserve requirements
  • Decrease the discount rate

Contractionary monetary policy actions: Increase interest rates

  • Increase the target fed funds rate
  • Open market operations: sell securities
  • Increase reserve requirements
  • Increase the discount rate


Want to know more about Federal Reserve policy options, go to: "Open Market Operations "

[Teacher Note:  A great classroom lesson to illustrate the impact of these monetary policy options is: "Lesson 10: "Macroeconomic Stabilization Policies and Institutions," Focus: Institutions and Markets, Council for Economic Education, 2003 (also in the "Virtual Economics CD Rom.")]

Changes in short-term interest rates will influence long-term interest rates, such as those on Treasury notes, corporate bonds, fixed-rate mortgages, and auto and other consumer loans. Long-term rates are affected not only by changes in current short-term rates but also by expectations about short-term rates over the rest of the life of the long-term contract. Generally, economic news or statements by officials will have a greater impact on short-term interest rates than on longer rates because they typically have a bearing on the course of the economy and monetary policy over a shorter period; however, the impact on long rates can also be considerable because the news has clear implications for the expected course of short-term rates over a longer time period.

In the current economic environment of slow growth, high unemployment , and slow credit markets, the Fed has adopted a stimulatory policy. Given the very low level of interest rates, over the last year, the Federal Reserve has taken additional measures to open up financial markets and stimulate spending.

[Note: Students should be able to identify the intended impact when the Fed uses its various policy options and tools.  If the Fed sells securities, what will happen?  If the Fed reduces rates, what will happen?  If the Fed increases reserve requirements, what will happen?]

During the recession, the Federal Reserve established several new programs to counter the "liquidity crisis" and the tight credit markets. These programs are intended to provide capital to different types of financial institutions "to strengthen market stability, improve the strength of financial institutions, and enhance market liquidity.  Most of these special program have been ended or "wound down" in the past year.

The first of these new Fed programs was the Term Auction Facility (TAF), created to improve bank liquidity. The TAF "allows a depository institution to place a bid for an advance from its local Federal Reserve Bank at an interest rate that is determined as the result of an auction. By allowing the Federal Reserve to inject term funds through a broader range of counterparties and against a broader range of collateral than open market operations, this facility could help ensure that liquidity provisions can be disseminated efficiently even when the unsecured interbank markets are under stress."

The common thread in these Fed programs' goals is to improve the balance sheets of financial institutions by supporting the value of their assets. One of the problems with bank holding has been uncertainty about the underlying value of the securities they hold. By replacing the banks' securities, such as mortgaged-backed securities, with those with more secure values, confidence in the banks will increase. In a more stable market with more predictable asset values, more narrowing and lending should result.

Remember, the Fed has two mandates, established by the Congress with the Employment Act of 1946. They are price stability (low inflation) and full employment. These two goals are often in conflict. When the economy is growing too slowly, demand for goods/services is low, and there is no anticipation of inflation. When growth is slow or negative, unemployment tends to be higher.

When the economy is growing too quickly, the opposite tends to result, higher inflation and low unemployment. Recently, the unemployment rate has fallen to 8.2 percent, but remains well above an acceptable level. 

[Teacher Note:  Ask: With currently low inflation, Fed policy can focus on growth and stimulating employment.  Is it worth the risk of inflation?]

ASSESSMENT ACTIVITY

Essay Questions:


1. During a recessionary period, why would the Federal Reserve and FOMC choose to keep interest rates low?

[Lower interest rates are an incentive for consumers to purchase and for businesses to invest in new productive capacity.]

2. 
How do low interest rates help to achieve the Fed's goal to stimulate the economy and help banks?

[If banks have more excess reserves to lend, other market rates will fall. When credit markets are tight, either because funds are not available or lenders are reluctant to take risks, economic activity (output) slows, unemployment increases and people are uncertain about their economic futures. The Fed's stimulatory policies seek to encourage people to spend, businesses to invest and banks to make more loans.]

CONCLUSION

At its September, 2012, meeting, the FOMC took a stronger stance to stimulate the economy, by directly targeting employment and the housing market - two weak spots in the recovery - by purchasing mortgage-backed securities.

According to the U.S. Securities and Exchange Commission, mortgage-backed securities 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," U.S. Securities and Exchange Commission.  URL: http://www.sec.gov/answers/mortgagesecurities.htm .  Cited September 14, 2012.]

By buying these securities from banks, the banks will have stronger balance sheets and a greater capacity to make loans to households and businesses.  The loans, hopefully, will result in more hiring.

Will it work?

With the unemployment rate hovering just over 9 percent, the FOMC has decided that more forceful measures are needed to get the economy going.   Keep an eye on the employment and real GDP growth data to see if it works.

EXTENSION ACTIVITY

The Federal Reserve District Banks

Take a look at data about your school's regional Federal Reserve district bank. 12 regional Federal Reserve banks serve the United States.

From the Map of the Twelve Federal Reserve System Districts , students should identify the Federal Reserve district bank that serves their school's geographic area.

Students can explore their Federal Reserve district bank's web site for information about the economic health of their region and programs available to area businesses and consumers. 

Discussion Questions:

  • Are economic conditions in your region of the United States similar, better or worse than national economic conditions? Growth? Employment/unemployment? Price level changes?
  • Are there any particular characteristics about your region that impact it's economic health - better or worse than other regions?
  • What do the president and/or other leaders of your Federal Reserve Bank have say about current regional economic conditions?
  • What programs and information services does your Federal Reserve Bank offer to businesses, consumers or schools?


Take another look at the map of the regional Federal Reserve Banks.  Do the sizes and boundaries of the twelve regions make sense to you?  Remember, this map was drawn in 1913 when the populations and levels of economic activity of the western and southern regions were much smaller parts of the total U.S. economy.

[Teacher Note:  Ask: Do you think the map would look different if the regions were established and the map was drawn today?]

[Note: Some Federal Reserve district banks have extensive educational resources and others do not.  Go to www.federalreserveeducation.org to access these publications.]