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INTRODUCTION

Federal Reserve Monetary Policy News Release: March 18, 2008

'The Federal Open Market Committee decided today to lower its target for the federal funds rate 75 basis points to 2-1/4 percent.

Recent information indicates that the outlook for economic activity has weakened further. Growth in consumer spending has slowed and labor markets have softened. Financial markets remain under considerable stress, and the tightening of credit conditions and the deepening of the housing contraction are likely to weigh on economic growth over the next few quarters.

Inflation has been elevated, and some indicators of inflation expectations have risen. The Committee expects inflation to moderate in coming quarters, reflecting a projected leveling-out of energy and other commodity prices and an easing of pressures on resource utilization. Still, uncertainty about the inflation outlook has increased. It will be necessary to continue to monitor inflation developments carefully.

Today’s policy action, combined with those taken earlier, including measures to foster market liquidity, should help to promote moderate growth over time and to mitigate the risks to economic activity. However, downside risks to growth remain. The Committee will act in a timely manner as needed to promote sustainable economic growth and price stability.'

The Fed and Monetary Policy

The Federal Open Market Committee (FOMC) of the Federal Reserve System (Fed) meets eight times annually, approximately every six weeks, to review economic and financial conditions, assess the risks to the nations' long-run goals of price stability, full employment and sustainable economic growth, and determine the appropriate stance of monetary policy.

The Federal Reserve influences the demand for and supply of the balances that depository institutions hold at Federal Reserve Banks and in this way alters the federal funds rate. The federal funds rate is the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight.

This focus on economic data highlights the March 18, 2008, FOMC announcement, explains the meaning of the report and the policy options of the Fed. Students will read and interpret the announcement, current and historical data, and discuss the impact of the policies on the overall economy and individuals.

TASK

  • Identify the current FOMC goals and policy actions.
  • Determine the intended impact of the policy actions on price stability, economic growth and employment.
  • Review the makeup of the Federal Open Market Committee, its responsibilities and policy options.
  • Determine how monetary policy actions impact the ability of banks to make loans.

PROCESS

Federal Reserve Monetary Policy News Release: March 18, 2008

'The Federal Open Market Committee decided today to lower its target for the federal funds rate 75 basis points to 2-1/4 percent.

Recent information indicates that the outlook for economic activity has weakened further. Growth in consumer spending has slowed and labor markets have softened. Financial markets remain under considerable stress, and the tightening of credit conditions and the deepening of the housing contraction are likely to weigh on economic growth over the next few quarters.

Inflation has been elevated, and some indicators of inflation expectations have risen. The Committee expects inflation to moderate in coming quarters, reflecting a projected leveling-out of energy and other commodity prices and an easing of pressures on resource utilization. Still, uncertainty about the inflation outlook has increased. It will be necessary to continue to monitor inflation developments carefully.

Today’s policy action, combined with those taken earlier, including measures to foster market liquidity, should help to promote moderate growth over time and to mitigate the risks to economic activity. However, downside risks to growth remain. The Committee will act in a timely manner as needed to promote sustainable economic growth and price stability.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Donald L. Kohn; Randall S. Kroszner; Frederic S. Mishkin; Sandra Pianalto; Gary H. Stern; and Kevin M. Warsh. Voting against were Richard W. Fisher and Charles I. Plosser, who preferred less aggressive action at this meeting.

In a related action, the Board of Governors unanimously approved a 75-basis-point decrease in the discount rate to 2-1/2 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, and San Francisco.'

The Fed and Monetary Policy

The Federal Open Market Committee (FOMC) of the Federal Reserve System (Fed) meets eight times annually, approximately every six weeks, to review economic and financial conditions, assess the risks to the nations' long-run goals of price stability, full employment and sustainable economic growth, and determine the appropriate stance of monetary policy.

The Federal Reserve influences the demand for and supply of the balances that depository institutions hold at Federal Reserve Banks and in this way alters the federal funds rate. The federal funds rate is the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight.

This focus on economic data highlights the March 18, 2008, FOMC announcement, explains the meaning of the report and the policy options of the Fed. Students will read and interpret the announcement, current and historical data, and discuss the impact of the policies on the overall economy and individuals.

Rationale for a Focus on Economic Data 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 focus on economic data 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.

Note: A 'basis point' is 1/100 of one percent. A 50 basis point change in an interest rate is the same as a change of .5 (1/2) percent. In this focus on economic data, the federal funds rate change will be referred to as either basis points or as a percentage change.


The Current Monetary and Financial Situation

On March 14, 2008, a very brief Federal Reserve press release stated, 'the Federal Reserve is monitoring market developments closely and will continue to provide liquidity as necessary to promote the orderly functioning of the financial system. The Board voted unanimously to approve the arrangement announced by JPMorgan Chase and Bear Stearns this morning.

The March 14 announcement was in response to widening problems in the financial markets; specifically, the crisis at Bear Sterns, a global investment banking, securities trading and brokerage firm. The Fed has taken several recent actions to improve liquidity in financial markets and support the banking system as a result of the so-called 'subprime mortgage meltdown'.

The Fed took several steps to address what it called 'orderly functioning of the financial system.' It acted to help the credit markets and supporting banks by lending directly to investment banks and accepting mortgage-backed debt as as collateral. The Fed announced that it will make Treasury securities available to investment banks and allow them to borrow from the Fed using the securities as collateral.

These unusual steps, outside the recent area of Federal Reserve actions, were taken not just because the economy is slowing - the usual reason for expansionary policies - but also because of the instability of the financial markets. At this time, the Fed's monetary policy responsibilities are supplemented by it's mission as a regulator of the banking system.

What is the 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 9, 2008.) The seven Governors of the Federal Reserve Board and five of the twelve Presidents of the Federal Reserve Banks make up the FOMC. 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 March 18, 2008 FOMC Announcement

The first paragraph of the Federal Open Market Committee announcement summarizes the current monetary policy change - this month it is the decision to reduce the target federal funds rate by 3/4 percent. The FOMC decreased the target federal funds rate by a total of 1215 basis-points (1-1/4 percent) in January, 2008.

A brief summary of the reasoning behind the decision is presented in the second and third paragraphs. The second paragraph of the March 18 announcement states that the Committee acted as it did because, 'the outlook for economic activity has weakened further. Growth in consumer spending has slowed and labor markets have softened.'

The third paragraph refers to the view that threat of inflation has increased and some indicators of inflation expectations have risen. The Committee expects inflation to moderate in coming quarters, but will continue to monitor inflation carefully.

The fourth paragraph suggests the Committee's future intent, that it 'will act in a timely manner as needed to promote sustainable economic growth and price stability.'

The next paragraph reports the vote for the policy. Most decisions are unanimous. In March, there were two dissenting votes by members who believed that the 3/4 percent change was not appropriate.

The last paragraph reports the Board of Governors approved a 75-basis-point decrease in the discount rate to 2-1/2 percent. Recent Board policy has been to keep the discount rate consistent with the federal funds rate.

Data Trends

The FOMC used policies actively throughout much of the 1990s and the last several 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.)

figure1

As inflationary pressures began to increase in 1994, the Federal Reserve began to raise rates, reaching 5 1/4 percent in mid-2007. The FOMC kept the fed funds rate steady at 5-1/4 percent in June and August, 2007.

In September, 2007, the FOMC began a series of rate cuts in response to slowing growth and tightening of credit conditions with 'the potential to intensify the housing correction and to restrain economic growth more generally. Today’s action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time.'

The FOMC reduced the rate at the October and December meetings, lowered the rate by a total of 1-1/4 percent in its two January 2008, meetings.

Monetary Policy 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.

Open Market Operations


The Federal Reserve buys and sells government securities and by doing so, increases or decreases banks' reserves and the 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' by buying or selling securities in the 'open market.'

When the Federal Reserve sells a bond, an individual or institution buys the bond with a debit on their account and transfers the funds 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 decreases and interest rates increase.

The opposite occurs when the Federal Reserve buys a bond. The Federal Reserve gives funds to the seller of the bond. The seller deposits the funds in their account. Their bank adds the amount to deposits and thus the money supply increases. The bank also presents the funds 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 can make loans with the remainder. Thus the money supply expands even further. As banks 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.

Recent FOMC policy actions have been intended to increase bank reserves and lower interest rates, in order to stimulate the economy, maintain stability in the banking system, and to relieve the so-called 'credit crunch'.

The Discount Rate

The Federal Reserve FOMC announcement refers initially to the change in the federal funds rate target. The announcement may also include a change in the Fed's 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.

From 2003 until mid-August 2007, the discount rate was almost always 1.0 percent above the federal funds rate. From August 17, 2007 until the current FOMC announcement rate, the discount rate has stayed at 1/4 to 1/2 percent higher than 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.

figure2

Reserve Requirements

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, depending on the size of the accounts. Reserves consist of the amount of currency that a bank holds in its vault and the bank's deposits at Federal Reserve banks. The required reserve is the portion 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.

Monetary Policy vs. Fiscal Policy

The FOMC uses monetary policies to react 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.

Another set of policy options, 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.

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.

Recently, Congress is authorized the use of an income tax rebates to stimulate the economy in a time of very slow growth and increasing unemployment. The rebate is intended to put more cash in the hands of consumers so that they will demand ore goods and services. Rebates of up to $600 will be sent to taxpayers beginning in May, 2008.

The Monetary Policy Debate


Since the passage of the The Employment Act of 1946 (U.S. Code Title 15 Section 1021), it has been the mandate of the federal government 'create and maintain useful employment, with fair compensation for the people employed, and to promote maximum employment, production, and purchasing power.' This legislation has evolved into the current system of using fiscal and monetary policies to stabilize the economy and promote growth.

Monetary policy is based on the assumption that the level of economic activity and the health of an economy can be impacted by changes in the money supply. The Federal Reserve attempts to influence money supply through monetary policies such as open market operations, the discount rate and bank reserve requirements. Money supply changes influence credit creation and the overall level of economic activity.

Economists constantly debate importance to the measurements of the money supply. M1 is the currency in circulation and in easily accessible deposit accounts. More broad measurements such as M2 and M3 include less liquid money supply, such as term deposits and money market mutual funds.

The debate extends from the appropriateness of central bank intervention in the economy to its effectiveness, considering the lengthy time lags inherent in the monetary policy process. History has shown that such intervention has been effective in times of extreme inflation and recession. The question is always one of timing - when and how much intervention is necessary. In a global economy, can the Federal Reserve effectively implement monetary policy to achieve its domestic stabilization and growth goals?

A 2005 report on 'The Effectiveness of Monetary Policy,' by Robert H. Rasche and Marcela M. Williams from the Federal Reserve Bank of St. Louis , sums up the debate. 'The case for consistently effective short-run monetary stabilization policies is problematic – there are just too many dimensions to uncertainty in the environment in which central banks operate.'

For the full Federal Reserve Bank of St. Louis report, go to: http://research.stlouisfed.org/wp/2005/2005-048.pdf

CONCLUSION

Review:

  • The Federal Open Market Committee decided to lower its target for the federal funds rate by 75 basis-points on March 18, 2008. This reduced the target for the federal funds rate to 2 1/4 percent.
  • The primary reasons for the reduction were slow growth, increased unemployment and lack of adequate liquidity in the banking system. The FOMC specifically stated, 'the outlook for economic activity has weakened further. Growth in consumer spending has slowed and labor markets have softened. Financial markets remain under considerable stress, and the tightening of credit conditions and the deepening of the housing contraction are likely to weigh on economic growth over the next few quarters.'
  • The Federal Reserve can use its monetary tools, primarily open market operations to increase bank reserves, loans, spending and investment.
  • Discussion: If you are a member of the FOMC, what will you look for in the coming months to determine what action, if any, to take at the May FOMC meeting?
    • GDP growth rate?
    • Inflation
    • Employment?
    • Stability of the credit markets?

ASSESSMENT ACTIVITY

 Students, click the start button below to test your knowledge on the FOMC lesson.

Next, complete these questions on the interactive notepad below.

 

  1. What are the Federal Reserve current observations and concerns?
     
  2. What tool will the Federal Reserve use to accomplish its goals?
     
  3. If, in the coming months, the Federal Reserve were to become less concerned about the slow growth of the economy, what is it likely to do?
     
  4. How do changes in monetary policy affect your family's spending and business spending in the economy?

EXTENSION ACTIVITY

Student Role Play:

  • Role play the March 18, 2008, FOMC meeting. The class should divide into two groups.
  • One group should develop the arguments for another cut in the federal funds rate.
  • The other group should develop the arguments against further cuts.
  • Identify the arguments for and against another cut in the federal funds rate.
  • Role play the meeting discussion with one student leading the discussion as Chairman Bernanke.

For much more detail on the FOMC decision-making process and the arguments for and against rate changes made in January, you can read the minutes of the FOMC 's January 29-30, 2008, meetings: www.federalreserve.gov/monetarypolicy/files/fomcminutes20080130.pdf