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Announcement

The Federal Open Market Committee decided today to raise its target for the federal funds rate by 25 basis points to 4-3/4 percent.

The slowing of the growth of real GDP in the fourth quarter of 2005 seems largely to have reflected temporary or special factors. Economic growth has rebounded strongly in the current quarter but appears likely to moderate to a more sustainable pace. As yet, the run-up in the prices of energy and other commodities appears to have had only a modest effect on core inflation, ongoing productivity gains have helped to hold the growth of unit labor costs in check, and inflation expectations remain contained. Still, possible increases in resource utilization, in combination with the elevated prices of energy and other commodities, have the potential to add to inflation pressures.

The Committee judges that some further policy firming may be needed to keep the risks to the attainment of both sustainable economic growth and price stability roughly in balance. In any event, the Committee will respond to changes in economic prospects as needed to foster these objectives.

In a related action, the Board of Governors approved a 25-basis-point increase in the discount rate to 5-3/4 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Dallas, and San Francisco.

The complete press release is available at: [EEL-link id='1749' title='www.federalreserve.gov/boarddocs/press/monetary/2006/20060328/' ]

Reasons for a Case Study on the Federal Open Market Committee

Following Federal Open Market Committee announcements, newspapers across the country have front-page stories about Federal Reserve actions to change the target for interest rates with a goal to either boost spending and employment in the U.S. economy or to slow growth in spending. The announcements reflect serious concerns with the state and direction of the economy and the resulting policy actions.

This case study is intended to guide students and teachers through an analysis of the actions the Federal Reserve is currently taking in an effort to reduce the amount of stimulus that it had been providing the economy. An understanding of monetary policy in action is fundamental to developing a thorough understanding of macroeconomics and the U.S. economy.

Guide To Announcement

The Federal Open Market Committee has increased the target for its federal funds rate at each of its meetings since June 2004. This is the fifteenth meeting in a row at which the target for the federal funds rate has been increased by .25 percent.

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 - increasing the target from 4.50 percent to 4.75 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. The target for one interest rate � the federal funds rate � is being increased from 4.50 percent to 4.75 percent.

The first paragraph is identical to the first paragraph in the January 31 announcement, except that then the rate was increased from 4.25 to 4.50 percent. See the copy of the announcement below for specific indications of changes.

A brief summary of the reasoning behind the decision is presented in the second and third paragraphs.

In the second paragraph, the slowing of growth in the final quarter of 2005 and the faster growth since are recognized. The committee believes the economy continues to expand, but will do so at a pace that can continue.

The increases in energy prices do not yet seem to have a serious effect on inflationary expectations. If increasing inflationary expectations were evidenced it is likely that the committee would have increased the target federal funds rate at a more rapid rate. The increases in productivity appear to be holding price pressures down.

However, the economy may be approaching a higher utilization of its capacity, which may increase inflationary pressures in the future.

The third paragraph is identical to that paragraph in the January announcement. The committee indicates that the risks are balanced between inflation (�price stability�) and sustainable economic growth. This means that the chances of increased inflation and chances of a slowdown in the economic growth are about equal. However, in order to maintain that balance, the committee believes that it will need to continue its increases in the target federal funds rate in the future. The phrase �further policy firming� means that the FOMC will continue its increase in the target federal funds rate in order to remove the stimulate effects of the low rates in 2002, 2003, and 2004.

The final sentence in the third paragraph is added simply to reassure analysts that if expectations of inflation change or rates of increase in spending slow, the FOMC will change its policy quickly and change the target for the federal funds rate in an appropriate manner. If increased inflationary pressure appear, the FOMC is likely to increase the target federal funds rate more rapidly. If growth in spending in the economy were to slow, the FOMC would be likely to decrease the target.

The Federal Reserve Board of Governors actually sets another interest rate known as the discount rate. This is the focus of the fifth paragraph. The process is one of approving requests for a change received from the twelve Federal Reserve Banks. In this announcement, the discount rate is increased by � of one percent to a level of 5. 75 percent. More discussion of the discount rate follows below.

There is also a fifth paragraph in a typical announcement. That paragraph will be discussed in the next case study.

Interactive Exercise

Please do the following multiple choice activity:

Comparison of the Current Announcement with the Previous Announcement

The Federal Open Market Committee decided today to raise its target for the federal funds rate by 25 basis points to 4-3/4 percent.

The slowing of the growth of real GDP in the fourth quarter of 2005 seems largely to have reflected temporary or special factors. Economic growth has rebounded strongly in the current quarter but appears likely to moderate to a more sustainable pace.

As yet, the run-up in the prices of energy and other commodities appears to have had only a modest effect on core inflation, ongoing productivity gains have helped to hold the growth of unit labor costs in check, and inflation expectations remain contained.

Still, possible increases in resource utilization, in combination with the elevated prices of energy and other commodities, have the potential to add to inflation pressures.

The Committee judges that some further policy firming may be needed to keep the risks to the attainment of both sustainable economic growth and price stability roughly in balance. In any event, the Committee will respond to changes in economic prospects as needed to foster these objectives.

Data Trends

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. See the figure showing changes in the target. (The periods of the 1990-1991 recession and the 2001 recession are shown in gray on the graph.)

Graph 1

Then as inflationary pressures began to increase in 1994, the Federal Reserve began to raise rates. 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.

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 and are continuing with the current increase. Certainly the FOMC will increase the target federal funds rate once more at its next meeting (unless conditions change, as referenced at the end of the third paragraph) and perhaps will increase the target twice or three times more.

Tools of the Federal Reserve

The Federal Reserve buys and sells bonds and by doing so, increases or decreases banks' reserves and banks' abilities to make loans. As banks increase or decrease loans, the nation's money supply increases or decreases. That, in turn, decreases or increases interest rates. The purchase and sale of bonds by the Federal Reserve is called open market operations. The Federal Reserve is �operating�, that is buying or selling, in the �open market� for U.S. Treasury securities.

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 opposite occurs when the Federal Reserve buys a bond. The Federal Reserve gives a check to the seller of the bond. The seller deposits the check in their account. Their bank adds to the amount to the deposits and thus the money supply increases. The bank also presents the check back to the Federal Reserve, which in turn adds the amount to the bank's reserves. Because the bank has to keep only a portion of those reserves, the bank makes loans with the remainder. Thus the money supply expands even further. As banks attempt to make more loans, interest rates fall.

Open market operations are the primary tool of the Federal Reserve. It is a tool that is often used and is 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 because the Federal Reserve has sold bonds, that interest rate is likely to increase. If the supply of reserves is increased because the Federal Reserve has purchased bonds, that interest rate is likely to decrease.

Banks earn profits by accepting deposits and lending part 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.

The Discount Rate

The discount rate is the interest rate the Federal Reserve charges banks if banks borrow reserves from the Federal Reserve itself. Banks may need to borrow reserves if they have made too many loans, have experienced withdrawals of deposits or currency, or have had fewer deposits than they expected.

In reality, banks seldom borrow reserves from the Federal Reserve and tend to rely more on borrowing reserves from other banks when they are needed. They will still pay an interest rate (the federal funds rate), but that is a rate determined in the market for reserves and influenced by the open market operations of the Federal Reserve.

The discount rate is most often changed along with the target for the federal funds rate, but the discount rate change does not have a very important effect as so few banks actually use that means of borrowing reserves. In this announcement, the discount rate is increased along with the federal funds rate.

Figure 2 shows the discount rate along with the federal funds rate. Notice that the discount rate typically changes along with the target for the federal funds rate. Prior to 2003, the discount rate was below the target federal funds rate. Since then the discount rate has been one percent above the target federal funds rate. That is an additional reason that there is little current borrowing of reserves directly from the Federal Reserve.

Graph 2

The Federal Reserve has one other tool that could be used to influence the expansion and contraction in the money supply and it will be introduced in the next FOMC case study.

How does Monetary Policy Work?

Monetary policy works by affecting the amount of money that is circulating in the economy, the level of interest rates, and changes in spending. 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. The bank then 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 and employment. In this case, 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 and less spending. 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.)

Interactive Exercise

Please do the following multiple choice activity.

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 May 10, 2006 .) 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 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.

The FOMC reacts to a slowing economy by expanding the money supply, lowering interest rates, and creating increased spending. The reaction to increasing inflationary pressures is to decrease the money supply, raise interest rates, and thereby slowing growth in spending.

Fiscal policy is the taxing and spending policies of the federal government. Those policies also have the potential to influence economic conditions whether deliberately or as an unintended consequence. If the economy is entering a recession, fiscal policy response might be to increase government spending and to lower taxes. If spending in the economy is growing too rapidly, the fiscal response might be to decrease government spending and to increase taxes.

In those processes, there will be debates in Congress about what to do with spending and taxes in order to stimulate or slow overall spending in the economy. These debates normally take a substantial amount of time. This lag points to one of the key differences between fiscal and monetary policy. Fiscal policy is much more difficult to implement but once the decision is made, it takes effect quickly. Monetary policy decisions are much easier to institute and more responsive to economic conditions, but actually take longer to change spending once the decision is made.

Questions

  1. What are the Federal Reserve current observations and concerns?
  2. What tool will the Federal Reserve use to accomplish its goals?
  3. If the Federal Reserve were to become concerned about a slowing of the economic expansion, what is it likely to do with its open market operations and the federal funds rate?
  4. How do changes in monetary policy affect your family�s spending and business spending in the economy?