“The Federal Open Market Committee decided today to lower its target for the federal funds rate by 25 basis points to 1 percent. In a related action, the Board of Governors approved a 25 basis point reduction in the discount rate to 2 percent."
Current Key Economic Indicatorsas of November 30, -0001
“The Federal Open Market Committee decided today to lower its target for the federal funds rate by 25 basis points to 1 percent. In a related action, the Board of Governors approved a 25 basis point reduction in the discount rate to 2 percent.
“The Committee continues to believe that an accommodative stance of monetary policy, coupled with still robust underlying growth in productivity, is providing important ongoing support to economic activity. Recent signs point to a firming in spending, markedly improved financial conditions, and labor and product markets that are stabilizing. The economy, nonetheless, has yet to exhibit sustainable growth. With inflationary expectations subdued, the Committee judged that a slightly more expansive monetary policy would add further support for an economy which it expects to improve over time.
“The Committee perceives that the upside and downside risks to the attainment of sustainable growth for the next few quarters are roughly equal. In contrast, the probability, though minor, of an unwelcome substantial fall in inflation exceeds that of a pickup in inflation from its already low level. On balance, the Committee believes that the latter concern is likely to predominate for the foreseeable future.
“Voting for the FOMC monetary policy action were Alan Greenspan, Chairman; Ben S. Bernanke; Susan S. Bies; J. Alfred Broaddus, Jr.; Roger W. Ferguson, Jr.; Edward M. Gramlich; Jack Guynn; Donald L. Kohn; Michael H. Moskow; Mark W. Olson; and Jamie B. Stewart, Jr.
“Voting against the action was Robert T. Parry. President Parry preferred a 50 basis point reduction in the target for the federal funds rate.
“In taking the discount rate action, the Federal Reserve Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of Boston, New York, St. Louis, Kansas City, and San Francisco. ”
This complete press release is available at: www.federalreserve.gov/boarddocs/press/monetary/2003/20030625/default.htm
Reasons For A Case Study On The Federal Reserve Open Market Committee
Following recent Federal Open Market Committee announcements, newspapers across the country have had front-page stories about the Federal Reserve actions to target interest rates and boost spending and employment in the U.S. economy. Attention increased as the economy entered a recession beginning in March of 2001. Real GDP actually fell in the first three quarters of 2001 and has increased only gradually since. Unemployment as steadily increased since March of 2001. The announcements reflect serious concerns with the state and direction of the economy. While most economists believe the recession ended at about the beginning of 2002, the economy is still in a fragile state and has not returned to the strength of years past.
There are an increasing number of news stories about the abilities of the Federal Reserve to prevent a new recession and to avoid a deflationary period.
This case study is intended to guide students and teachers through an analysis of the actions the Federal Reserve began to take in 2001 in an effort to strengthen the economy. An understanding of monetary policy in action is fundamental to developing a thorough understanding of macroeconomics and the U.S. economy.
[NOTE: The material in this case study in italics is not included in the student version. This initial case study of the semester introduces relevant concepts and issues. Subsequent case studies following FOMC announcements will describe the announcement and add concepts and complexity throughout the semester.
You may wish to use the following larger versions of the graphs and tables from this lesson for overhead projection or handouts in class:
Guide To Announcement
From January 3 to December 11 of 2001, the Federal Reserve Open Market Committee (FOMC) lowered the target federal funds rate 11 times from 6.50 percent to 1.75 percent. On November 6, 2002, the Federal Reserve Open market committee lowered the target federal funds rate by an additional .5 percent to 1.25 percent. At all 2002 meetings before the cut at the November meeting, the FOMC decided to leave the federal funds rate unchanged.
The first paragraph of this announcement summarizes the current monetary policy changes - this month it is the decision to lower the target federal funds rate by one-quarter of one percent. This is the lowest target federal funds rate in forty-five years. (There are 100 basis points in one percentage point. Thus a decrease of 25 basis points is .25 percent.) The Federal Reserve Board of Governors also sets the discount rate, through a technical process of approving requests of the twelve Federal Reserve Banks. (See the very last paragraph of the announcement.) The discount rate also was also lowered by one-quarter of one percent at this meeting.
In the second paragraph, the FOMC discusses the current economic situation and the reasoning behind their decisions. It is stated “the accommodative stance of monetary policy, coupled with still robust underlying growth in productivity, is providing important ongoing support to economic activity.” However, the FOMC believes that the economy is not yet growing at its potential levels. It has “yet to exhibit sustainable growth.” Inflation is not a current problem. Thus the committee believes that some further monetary stimulus is needed.
The third paragraph begins by stating that the FOMC believes the risks of spending growing at a slower or faster rate than the potential output of the economy are balanced. That is, at the present time, it is not concerned with too much or too little growth in spending. However, the FOMC is concerned with the possibility of falls in inflation, more than it is with increases in the rate of inflation. While the committee is stating that the probability is “minor”, this statement says that it does want to prevent and is concerned with the possibility of deflationary conditions.
The fourth and fifth paragraphs describe the votes of the FOMC members on changing the target federal funds rate. In the past, there has been a lag between the announcement and the publication of this information in the minutes. This change, which was implemented last year, is one step in a FOMC trend toward releasing more information immediately following their meetings. All but one of the members of the FOMC voted to lower the target federal funds rate by one-quarter of one percent. One member voted in favor of a larger decrease.
During the last half of the 1990s, real GDP grew at rates more rapid than those in the first half of the decade. That growth began to slow at the end of 2000. Real GDP increased at annual rates of 4.1 percent and 3.8 percent in 1999 and 2000. During the first three quarters of 2001, real GDP actually decreased. For the year as a whole, real GDP increased only by .3 percent. The slowing growth over the last two quarters of 2000 and the first three quarters of 2001 was one indication of the need to use a monetary policy that would boost spending in the economy. The FOMC responded by cutting the target federal funds rate throughout the year as noted above.
During 2002, real GDP growth rebounded slightly as real GDP increased 2.4 percent. In the first quarter of 2003, the annual rate of growth was slightly less, 1.9 percent. While stimulative monetary policy surely had a positive effect on real GDP, the growth was not fast enough to match the increased potential real GDP and to keep unemployment low. (For more on changes in the rate of growth of real GDP and the current recession, see the most recent GDP Case Study.)
The FOMC engaged in an active monetary policy throughout much of the 1990s. The FOMC had lowered the target federal funds rate in a series of steps beginning in July of 1990 until September of 1992, all in response to a recession beginning in July of 1990 and ending in March of 1991. Then as inflationary pressures began to increase in 1994, the Federal Reserve began to raise rates in February. In response to increased inflationary pressures once again in 1999, the FOMC raised rates six times from June 1999 through May of 2000. Throughout the 1990s, the FOMC changed the target federal funds rate in all but one year. In three years, the rate was changed only a single time.
On November 26, 2001, the National Bureau of Economic Research (NBER) announced though its Business Cycle Dating Committee that it had determined that a peak in business activity occurred in March of 2001. That signals the official beginning of a recession.
The NBER defines a recession as a "significant decline in activity spread across the economy, lasting more than a few months, visible in industrial production, employment, real income, and wholesale-retail trade." The data showed a decline in employment. Unemployment has also increased. Real income growth slowed but did not decline. Manufacturing and trade sales and industrial production have both declined and are only now beginning to turn around.
While the common media definition of a recession is two consecutive quarters of decline in real GDP, this recession was announced as beginning before quarterly real GDP actually declined.
The last recession began in July of 1990 and ended in March of 1991, a period of eight months. However, the beginning of the recession was not announced until April of 1991 (after the recession had actually ended). The end of the recession was announced in December of 1992, almost 21 months later. One of the reasons the end of the recession was so difficult to determine was the economy did not grow very rapidly even after it came out a period of falling output and income.
Many observers are now stating that the 2001 recession may have ended in December of 2001 or very early in 2002. However, the National Bureau of Economic Research has not yet declared the end of the recession.
Deflation is the opposite of inflation. We experience deflation if prices across the economy, that is if most prices, are falling. This announcement refers to the possibility of “an unwelcome substantial fall in inflation.” As recent inflation has been quite low, the FOMC announcement points to concerns that inflation might turn into a deflation.
Why should we be concerned with falling prices? It sounds good. The concern is that if prices throughout the economy are falling, consumers and businesses may reduce spending because they expect even lower prices in the near future. That would put further downward pressure on spending, production, and employment. In addition, businesses and individual debtors may face increased pressures. As sales (and incomes) and therefore profits fall in nominal terms, the amount of debt does not change. Instead it becomes an ever-increasing percentage of income and makes it more difficult to make timely payments.
Federal Open Market Committee (FOMC)
The primary function of the FOMC is to direct monetary policy for the U.S. economy. The FOMC meets about every six weeks. (The next meeting is August 12.) The seven Governors of the Federal Reserve Board and five of the twelve Presidents of the Federal Reserve Banks make up the committee. Governors are appointed by the U.S. President and confirmed by the U.S. Senate. The Boards of each Federal Reserve Bank select the presidents of the banks.
Tools of the Federal Reserve
Open Market Operations
The Federal Reserve buys and sells bonds and by doing so, increases or decreases banks' reserves and their abilities to make loans. As banks increase or decrease loans, the nation's money supply changes. That, in turn, decreases or increases interest rates. Open market operations are the primary tool of the Federal Reserve. They are often used and are quite powerful. This is what the Federal Reserve actually does when it announces a new target federal funds rate. The federal funds rate is the interest rate banks charge one another in return for a loan of reserves. If the supply of reserves is reduced, that interest rate is likely to increase.
Banks earn profits by accepting deposits and lending some of those deposits to someone else. They sometimes charge fees for establishing and maintaining accounts and always charge borrowers an interest rate. Banks are required by the Federal Reserve System to hold reserves in the form of currency in their vaults or deposits with Federal Reserve System.
When the Federal Reserve sells a bond, an individual or institution buys the bond with a check on their account and gives the check to the Federal Reserve. The Federal Reserve removes an equal amount from the customer’s bank’s reserves. The bank, in turn, removes the same amount from the customer’s account. Thus, the money supply shrinks.
[The Federal Reserve engages in open market operations on a daily basis-not just when they change the target federal funds rate. The amount that banks hold in reserves changes throughout the year and the Federal Reserve will buy or sell bonds to influence reserve levels and maintain the target federal funds rate at the desired level.]
The discount rate is the interest rate the Federal Reserve charges banks if banks borrow reserves from the Federal Reserve itself. Banks seldom borrow reserves from the Federal Reserve and tend to rely more on borrowing reserves from other banks when they are needed. The discount rate is often changed along with the discount rate, but the change does not have a very important effect. In this announcement, the discount rate is not changed.
[NOTE: In January of 2003, the discount rate was changed to a level one-half of one percent above the target federal funds rate. The discount rate had normally been about one-half of a percent less than the target federal funds rate. Technical aspects of borrowing from the Fed were also changed at the same time. The basic functions of monetary policy were not changed.]
Banks are required to hold a portion (either 10 or 3 percent of most deposits, depending upon the size of the bank) of some of their deposits in reserve. Reserves consist of the amount of currency that a bank holds in its vaults and its deposits at Federal Reserve banks. If banks have more reserves than they are required to have, they can increase their lending. If they have insufficient reserves, they have to curtail their lending or borrow reserves from the Federal Reserve or from another bank that may have extra, or what are called excess, reserves. The requirement is seldom changed, but it is potentially very powerful.
For more background on the Federal Reserve and resources to use in the classroom, go to: www.federalreserve.gov.
How does Monetary Policy Work?
Monetary policy works by affecting the amount of money that is circulating in the economy. The Federal Reserve can change the amount of money that banks are holding in reserves by buying or selling existing U.S. Treasury bonds. When the Federal Reserve buys a bond, the seller deposits the Federal Reserves' check in her bank account. As a bank’s reserves increase, it has an increased ability to make more loans, which in turn will increase the amount of money in the economy.
Competition among banks forces interest rates down as banks compete with one another to make more loans. If businesses are able to borrow more to build new stores and factories and buy more computers, total spending increases. Consumer spending that partially depends upon levels of interest rates (automobile and appliances, for example) is also affected. Output will tend to follow and employment may also increase. Thus unemployment will fall. Prices may also increase.
When the Federal Reserve employs an expansionary monetary policy, it buys bonds in order to expand the money supply and simultaneously lower interest rates. Although gross domestic product and investment increase, this may also stimulate inflation. If growth in spending exceeds growth in capacity, inflationary pressures tend to emerge. If growth in spending is less than the growth in capacity, then the economy will not be producing as much as it could. As a result, unemployment may rise.
When the Federal Reserve adopts a restrictive monetary policy it sells bonds in order to reduce the money supply and this results in higher interest rates. A restrictive monetary policy will decrease inflationary pressures, but it may also decrease investment and real gross domestic product. See the Inflation Case Study for a more detailed discussion of inflation.
Comparison of Monetary and Fiscal Policy
The FOMC has been reacting to the slowing economy over the past year. While the monetary policy has not been sufficient to prevent a recession, it surely has made the recession milder than it would have been otherwise and has likely contributed to the recession ending sooner.
Fiscal policy, the taxing and spending policies of the federal government, has the potential to influence economic conditions. Throughout 2003, there have been debates in Congress about what to do with spending and taxes in order to stimulate spending. These debates continue and little has been accomplished to date. This points to one of the key differences between fiscal and monetary policy. Fiscal policy is much more difficult to implement. However, fiscal policy, once adopted, will be likely to have a faster effect on spending. Monetary policy decisions are much easier to institute and more responsive to economic conditions, but take longer to actually have an effect.
Creation of the Federal Open Market Committee
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, for four-year terms.
Only one member of the Board may be selected from any one of the twelve Federal Reserve Districts. In making appointments, the President is directed by law to select a "fair representation of the financial, agricultural, industrial, and commercial interests and geographical divisions of the country." These aspects of selection are intended to ensure representation of regional interests and the interests of various sectors of the public.
The seven Board members constitute a majority of the 12-member Federal Open Market Committee (FOMC), the group that makes the key decisions affecting the cost and availability of money and credit in the economy. The other five members of the FOMC are Reserve Bank presidents, one of whom is the president of the Federal Reserve Bank of New York. The other Bank presidents serve one-year terms on a rotating basis. By statute the FOMC determines its own organization, and by tradition it elects the Chairman of the Board of Governors as its Chairman and the President of the New York Bank as its Vice Chairman.
[Businesses and consumers do not normally change their spending plans immediately upon an interest rate change. Businesses must reevaluate, make new decisions and order reductions or expansions in production and expenditures. This means that months pass before spending is affected. Monetary policy typically has a short policy lag (the time it takes to create and implement policy) and a long expenditure lag (the time it takes businesses and consumers to adjust to the new interest rates). The total lag time is usually 9-12 months and varies a good bit. Thus when the Federal Reserve changes interest rates, their decisions will affect economic conditions in approximately a year from the time of the change.
Fiscal policy (changing taxes and government spending) also has a significant lag time. It typically has a long policy lag (the time it takes Congress to approve a tax or spending change) and a short expenditure lag (the time it takes consumers to experience the tax changes and government to change spending). The combined lags may be anywhere from one to almost five years.]
What are the Federal Reserve current observations and concerns?
[While the Federal Reserve is optimistic about conditions over the long term, there still is concern that economic conditions are not rapidly improving.]
What tools can the Federal Reserve use?
[The Federal Reserve can buy or sell bonds, which in turn lower or increase the federal funds rate. The Federal Reserve can also change reserve requirements and the discount rate]
If the Federal Reserve is concerned about lack of economic expansion, what is it likely to do with its open market operations and the federal funds rate?
[The Federal Reserve would purchase bonds to expand the money supply and reserves and lower the target federal funds rate.]
If the Federal Reserve is concerned about lack of economic expansion and decided to use changes in reserve requirement and the discount rate, what would it do?
[The Federal Reserve would lower reserve requirements and decrease the discount rate.]
How do changes in monetary policy affect spending in the economy?
[If banks have fewer reserves, they cannot make as many loans. The reduction in loans and the resulting higher interest rates discourage business (and consumer) borrowing and spending. In the case of too little growth or a reduction in spending, the increased availability of loans and lower interest rates may encourage businesses and consumers to increase their spending.]
If the Federal Reserve is concerned about a lack of significant increases in output and employment, it should do which of the following?
|Raise or lower the target federal funds rate?||[lower]|
|Increase or decrease the growth of the money supply?||[increase]|
|Buy or sell bonds?||[buy]|
|Raise or lower the discount rate?||[lower]|
|Raise or lower the required reserve ratio?||[lower]|