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 of either boosting spending and employment in the U.S. economy or slowing growth in spending and employment. The announcements often reflect serious concerns with the state and direction of the economy and recommend appropriate policy actions. 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. An understanding of monetary policy in action is fundamental to developing a thorough understanding of macroeconomics and the U.S. economy.
Current Key Economic Indicatorsas of January 19, 2015
The Consumer Price Index for All Urban Consumers (CPI-U) declined 0.3 % in November on a seasonally adjusted basis. The gasoline index posted its sharpest decline since December 2008 and was the main cause of the decrease in the seasonally adjusted all items index. The all items index increased 1.3% over the last 12 months, a notable decline from the 1.7 percent figure from the 12 months ending October.
The unemployment rate for December, 2014, fell to 5.6%, and the economy added 252,000 jobs, according to the Bureau of Labor Statistics. Job gains occurred in professional and business services, construction, food services, health care and manufacturing. The long-term unemployed was unchanged, accounting for approximately 32% of the unemployed.
Real gross domestic product (GDP) increased 5.0 percent in the third quarter of 2014, according to the “third” or final estimate released by the Bureau of Economic Analysis. The second estimate for the third quarter was 3.9%. The second quarter growth of GDP was 4.6%
The FOMC believes that the labor market is continuing to modestly improve and will continue to do so. Household and business spending are also increasing, and while the housing market continues to lag, the outlook for the economy is positive. Inflation is below the 2% target, largely due to the decline in energy prices. The FOMC believes that inflation will rise toward the target as the labor market tightens and energy prices return to their normal level. The FOMC reaffirmed its position of a low federal funds rate, possibly continuing beyond the return of inflation and unemployment rates to sustainable levels.
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 of either boosting spending and employment in the U.S. economy or slowing growth in spending and employment. The announcements often reflect serious concerns with the state and direction of the economy and recommend appropriate policy actions.
This case study 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. An understanding of monetary policy in action is fundamental to developing a thorough understanding of macroeconomics and the U.S. economy.
[Notes to Teacher:
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. This case adds an explanation of the discount rate and a comparison with the previous announcement. (Slides showing each paragraph of the excerpts of the announcement are included in the accompanying PowerPoint slides.)
You may wish to use the following larger versions of the graphs and tables from this lesson for overhead projection or handouts in class:
The Federal Open Market Committee decided today to keep its target for the federal funds rate at 5-1/4 percent.
Economic growth appears to have been moderate during the first half of this year, despite the ongoing adjustment in the housing sector. The economy seems likely to continue to expand at a moderate pace over coming quarters.
Readings on core inflation have improved modestly in recent months. However, a sustained moderation in inflation pressures has yet to be convincingly demonstrated. Moreover, the high level of resource utilization has the potential to sustain those pressures.
In these circumstances, the Committee's predominant policy concern remains the risk that inflation will fail to moderate as expected. Future policy adjustments will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.
Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Thomas M. Hoenig; Donald L. Kohn; Randall S. Kroszner; Cathy E. Minehan; Frederic S. Mishkin; Michael H. Moskow; William Poole; and Kevin M. Warsh.
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 7, 2007.) 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.
Guide To Announcement
The first paragraph of the Federal Open Market Committee announcement summarizes the current monetary policy change - this month it is the decision to keep the target constant. The FOMC not changed the target federal funds rate since an increase of one-quarter of one percent at its June 2006 meeting.
A brief summary of the reasoning behind the decision is presented in the second and third paragraphs. The second paragraph states that growth slowed in the first part of the year. One of the important factors was a slowing in growth in the housing industry. The previous meeting's announcement stated that "recent indicators have been mixed". This relatively minor change simply acknowledges the actual slower growth. The references to the housing market and the expected expansion are identical to the previous announcement.
The third paragraph is almost identical to the description in the previous announcement. In the previous announcement, the statement was made that core inflation had increased. This announcement simply states that the higher inflation remains. Members of the FOMC are concerned over current inflation levels but believe that inflationary pressures are likely to lessen. However, the economy is experiencing a high utilization of its capacity, which may increase inflationary pressures in the future.
The fourth paragraph is identical to that in the previous announcement. The committee is concerned that inflation may fail to moderate. However, any future decisions will depend upon future events and data.
The final paragraph reports the vote for the policy. Most decisions are unanimous, as this one is. The December announcement was an example where one member voted for an increase of ¼ percent in the federal funds rate. That member believed that inflationary pressures are more serious and monetary policy should address those pressures more aggressively. (That member has rotated off the committee.)
The FOMC used policies actively throughout much of the 1990s and the last seven years. The FOMC 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 figure 1 showing changes in the target. (The periods of the 1990-1991 recession and the 2001 recession are shown in gray on the graph.)
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. The recession began in March of 2001 and ended in November of 2001. The target federal funds rate was lowered in January of 2001 with the last of the direct series of lower rates ending in December of 2001. (Two more decreases followed – one in mid-2002 and a second in mid-2003.)
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 increases in the target were undertaken and continued until June 2006. The target federal funds rate has remained the same since.
Tools of the Federal Reserve
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. However, banks do not lend all of their deposits. Banks are required by the Federal Reserve System to hold a portion of their deposits as reserves in the form of currency in their vaults or deposits with Federal Reserve System.
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 bonds.
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 account of the customer who purchased the bond. 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 the amount to 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 the 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.
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. Banks can borrow reserves from the Federal Reserve or from other banks.
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 not mentioned as neither it nor the target federal funds rate are changed.
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.
Banks are required by law to hold a portion of some of their deposits in what are called reserves. The portion varies depending upon the type of deposits and the size of the bank. Most are required to have either 3 or 10 percent of their deposits on reserve. Reserves consist of the amount of currency that a bank holds in its vaults and the bank's deposits at Federal Reserve banks. These are portions of a bank's deposits that cannot be loaned to other customers.
If banks have more reserves than they are required to have, they can increase their lending. If they have insufficient reserves, that is, less than they are required to have, they have to curtail their lending or borrow reserves from the Federal Reserve or from another bank. If another bank has more reserves than they are required to maintain, those extra reserves are called excess reserves. The reserve requirement is seldom changed, but it has a potentially very large effect on the ability to make loans and thus on interest rates.
If the Federal Reserve were to increase the reserve requirements, banks would have to curtail loans and the money supply would shrink. If the reserve requirements were lowered, banks would have excess reserves and they could increase the amount and number of loans they make.
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 will likely increase as spending increases. 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 cause real gross domestic product to decrease or to increase more slowly.
See the Inflation Case Study for a more detailed discussion of inflation.
Timing of Policy Effects
Press coverage of FOMC announcements often refers to what is happening to current inflation and changes in production. Monetary policy is not instantaneous in its effects. The process just outlined takes time to work its way through the economy. The FOMC realizes this and pays attention to current data only as a means of forecasting what is going to happen in the future. One should be cautious in forecasting exactly when a change a monetary policy will begin to have its full effects as those time lags vary. However, a working rule might be that a change in monetary policy will have its nine to twelve months from the time it is initiated.
Have your students click the start button below for an online interactive activity.
Comparison of Monetary and Fiscal Policy
The FOMC reacts to a slowing economy by expanding the money supply, lowering interest rates, and thus encouraging increased spending. The FOMC 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 of changes in taxes and spending adopted for reasons other than to influence economic conditions. 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 can have an effect quickly. Monetary policy decisions are much easier to institute and more responsive to economic conditions, but may actually take longer to change spending once the decision is made.
What are the Federal Reserve current observations and concerns?
[The Federal Reserve believes that the economy is growing slowly with some inflationary pressure. The FOMC appears to be a bit more satisfied with the moderate growth in real GDP and the decreases in the rates of change in inflation as measured by the core indexes. The FOMC is concerned with the effects of high resource utilization on inflation. That is, the economy appears to be very near the full-employment level of output.]
What tool will the Federal Reserve use to accomplish its goals?
[The Federal Reserve can buy or sell U.S. Treasury bonds, which in turn will lower or increase the federal funds rate. In this case, the Federal Reserve is not changing its monetary policy. Over time, as the economy expands, the Federal Reserve tends to increase the money supply. No change in monetary policy means that Federal Reserve is continuing to expand the money supply slowly, not increasing or decreasing the growth in money. Given this announcement the FOMC is most likely to raise the target federal funds rate if it makes any change in the near future.]
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?
[The Federal Reserve would purchase more bonds to expand the money supply and bank reserves and that would lower the federal funds rate. The goal would be to increase overall spending in the economy.]
How do changes in monetary policy affect your family's spending and business spending in the economy?
[If the Federal Reserve is selling bonds, banks will have decreased reserves due to decreased deposits. With the decreased reserves, banks will have to decrease the number and size of loans. The decrease in loans and the resulting higher interest rates discourage business (and consumer) borrowing and spending. The decreased spending in the economy should result in less inflationary pressure.]