Explore the connection between the economic indicators and real-world issues. These lessons typically can be done in one class period.
Current Key Economic Indicatorsas of November 30, -0001
The Federal Open Market Committee decided today to raise its target for the federal funds rate by 25 basis points to 4 percent.
Elevated energy prices and hurricane-related disruptions in economic activity have temporarily depressed output and employment. However, monetary policy accommodation, coupled with robust underlying growth in productivity, is providing ongoing support to economic activity that will likely be augmented by planned rebuilding in the hurricane-affected areas. The cumulative rise in energy and other costs has the potential to add to inflation pressures; however, core inflation has been relatively low in recent months and longer-term inflation expectations remain contained.
The Committee perceives that, with appropriate monetary policy action, the upside and downside risks to the attainment of both sustainable growth and price stability should be kept roughly equal. With underlying inflation expected to be contained, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured. Nonetheless, the Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability.
Voting for the FOMC monetary policy action were: Alan Greenspan, Chairman; Timothy F. Geithner, Vice Chairman; Susan S. Bies; Roger W. Ferguson, Jr.; Richard W. Fisher; Donald L. Kohn; Michael H. Moskow; Mark W. Olson; Anthony M. Santomero; and Gary H. Stern.
[A last paragraph is not shown.]
Notes to Teachers
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:
Have your students do the following multiple choice activity:
Reasons for a Case Study on the Federal Open Market Committee (FOMC)
Following most Federal Open Market Committee announcements, newspapers across the country have front-page stories about the Federal Reserve actions to change interest rates and increase or decrease spending and employment in the U.S. economy. Attention increased when growth in spending and output slowed in the economy in late 2000 and 2001. The economy entered a recession in March of 2001 and came out of the recession in November of that year. We then began to grow but without a rise in employment (in fact, employment continued to fall). The Federal Reserve primary concern was to stimulate spending, production, and employment in the economy.
Once the economy began to grow, the focus shifted to reduction of the monetary stimulus and to potential inflation. The current announcement reflects confidence that economic conditions are good, some concern that growth may be slowing, and that attention should be paid to the possibility of increases in inflation in the future.
This case study is intended to guide students and teachers through an analysis of the recent and current actions of the Federal Reserve. An understanding of monetary policy in action is fundamental to developing a thorough understanding of macroeconomic policy, the U.S. economy, and financial markets.
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 December 13.) The seven Governors of the Federal Reserve Board and five of the twelve Presidents of the Federal Reserve Banks make up the committee. The staff of the Federal Reserve implements the recommended policies.
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 seven Board members constitute a majority of the 12-member FOMC, the group that makes the key decisions regarding monetary policy. The other five members of the FOMC are Reserve Bank presidents, one of whom is always the president of the Federal Reserve Bank of New York. The other Bank presidents serve one-year terms on a rotating basis. Traditionally, the Chairman of the Board of Governors serves as the Chairman of the FOMC.
Guide To Announcement
Beginning in June of 2004, the Federal Open Market Committee has increased the target for its federal funds rate at each of its meetings.
The first paragraph of the announcement summarizes the current monetary policy changes - this month it is the decision to increase the target federal funds rate for the twelfth meeting in a row. It is increasing the target from 3.75 percent to 4 percent.
The language used to describe the increase assumes an understanding the definition of a basis point. There are 100 basis points in one percent of interest. Thus, an increase of 25 basis points is equal to one-quarter of one percent.
In the second and third paragraphs, the reasoning behind the decision is presented. Reference is made to negative economic effects of the damage done by the hurricanes in the southeastern part of the U.S. The statement that “monetary accommodation, coupled with robust underlying growth in productivity, is providing support to economic activity…” has two primary parts. “Monetary accommodation” refers to the rather dramatic lowering of interest rates from the beginning of 2001 to June of 2003. The FOMC members believe that even though interest rates have been increased since that time, they are still relatively low and still have a stimulative effect on the economy. Productivity continues to increase and that also has a positive effect on growth in output.
The committee does recognize potential inflationary changes, but points to the relative low increases in price indexes when prices of food and energy are removed and to what it believes are expectations that prices will be relatively stable for some time.
In the third paragraph the committee indicates that the risks are balanced between inflation (“price stability”) and sustainable growth. This means that the chances of increased inflation and chances of a slowdown in the economic growth are about equal. Because it is not concerned with immediate inflationary pressures and believes that the economy is growing rapidly enough, it can raise the target and not risk contributing to either problem. The pace being “measured” has been interpreted by most observers as meaning that the target will be increased by one-quarter or one-half of a percentage point at the next several meetings. The final sentence is added simply to reassure analysts that if expectations of inflation change, the FOMC will change its policy quickly and increase the target more rapidly.
The fourth paragraph describes the votes of the FOMC members on changing the target for the federal funds rate. In the past, there has been a lag between the announcement of the policy and the publication of this information about votes. This change, which was implemented a little over two years ago, is one step in a FOMC trend toward releasing more information immediately following their meetings. All members of the FOMC voted to leave the target federal funds rate unchanged.
The Federal Reserve Board of Governors actually sets another interest rate known as the discount rate, through a technical process of approving requests of the twelve Federal Reserve Banks. The discount rate change was described in a last paragraph of the announcement and will be discussed in the next FOMC case study.
The FOMC used policies actively 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 Federal Reserve raised rates six times from June 1999 through May of 2000. Those changes are obvious in the graph showing the recent history of the target for the federal funds rate.
Growth began to slow at the end of 2000. The slowing growth was one indication of the need for a change in monetary policy that would boost spending in the economy. The FOMC responded by cutting the target federal funds rate throughout the year.
Then as the economy began to recover from the recession and the FOMC turned to concerns that the economy did not need as much stimulation, a series of “measured” increases in the target were undertaken.
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 June 29 and 30, 2005. 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. The current committee is described in the fourth paragraph of the announcement. (There are only eleven members listed as there is currently one opening on the committee as a Governor is in the process of leaving and has not been replaced.)
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 for its 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.
HOW OFTEN DOES THE FEDERAL RESERVE ENGAGE IN OPEN MARKET OPERATIONS?
[The Federal Reserve engages in open market operations on a daily basis - not just when they change the target for the federal funds rate. The amount of money that banks hold in reserves changes throughout the year and the Federal Reserve will buy or sell bonds to maintain the target federal funds rate at the desired level.]
The Federal Reserve also has two other tools that may be used to influence expansion and contraction in the money supply. Those tools – changes in the discount rate and change in the required reserve ratio – will be discussed in future case studies.
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 Reserve’s check in her bank account. The bank’s deposits and reserves increase. It has an increased ability to make 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, machines, and tools, 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. There may also be some upward pressure on prices.
When the Federal Reserve adopts a restrictive monetary policy it sells bonds in order to reduce the money supply. This results in higher interest rates. A restrictive monetary policy will decrease inflationary pressures, but it may also decrease investment spending and real gross domestic product. (See the Inflation Case Study for a more detailed discussion of inflation.)
Have your students do the following multiple choice activity:
What are the Federal Reserve current observations and concerns?
[The Federal Reserve believes that the economy is growing without significant inflationary pressure. It goal is to remove the stimulative pressure created by low interest rates.]
What tool will the Federal Reserve use to accomplish its goals?
[The Federal Reserve can buy or sell bonds, which in turn lower or increase the federal funds rate. To reduce the stimulative effects, the FOMC is increasing the target for the federal funds 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.]
How do changes in monetary policy affect spending in the economy?
[If banks have greater reserves due to increased deposits, they can make more loans. The increase in loans and the resulting lower interest rates encourage business (and consumer) borrowing and spending. The increased spending should result in increased business production and employment.]
How long does it take monetary policy to have an effect on the economy?
[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.]