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This lesson focuses on the October 29, 2008, announcement by the Federal Open Market Committee on the current Federal Reserve monetary policy actions and goals. 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. Through this lesson, students will better understand the dynamics of the U.S. economy and current economic conditions.

KEY CONCEPTS

Interest Rate, Macroeconomic Indicators, Monetary Policy, Open Market Operations, Price Stability, Tools of the Federal Reserve

STUDENTS WILL

  • Identify the current monetary policy goals of the Federal Reserve and the Federal Open Market Committee.
  • Define the Federal Funds Rate and explain its use as a monetary policy tool.
  • Determine the factors that have recently influenced monetary policy goals.
  • Identify the policy options available to the Federal Reserve to stimulate and/or contract the economy.
  • Identify the policy trade-offs the Federal Reserve must consider under the current economic conditions.

Current Key Economic Indicators

as of May 5, 2013

Inflation

On a seasonally adjusted basis, the Consumer Price Index for All Urban Consumers decreased 0.2 percent in March after increasing 0.7 percent in February. The index for all items less food and energy rose 0.1 percent in March after rising 0.2 percent in February.

Employment and Unemployment

Total nonfarm payroll employment rose by 165,000 in April, and the unemployment rate was little changed at 7.5 percent. Employment increased in professional and business services, food services and drinking places, retail trade, and health care.

Real GDP

Real gross domestic product increased at an annual rate of 2.5 percent in the first quarter of 2013 (that is, from the fourth quarter to the first quarter), according to the "advance" estimate released by the Bureau of Economic Analysis. In the fourth quarter, real GDP increased 0.4 percent.

Federal Reserve

To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens. In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent...

INTRODUCTION

The Federal Open Market Committee of the Federal Reserve System meets approximately every six weeks to reevaluate the nation's monetary policy goals and, if needed, revise the target for the federal funds rate (fed funds rate). The fed funds rate is the interest rate at which banks lend their excess reserve balances at the Federal Reserve to other banks, usually overnight.

This lesson focuses on the October 29, 2008, announcement by the Federal Open Market Committee on the current Federal Reserve monetary policy actions and goals.

[Note to teachers: This lesson is intended to guide students through an analysis of the actions the Federal Reserve is taking and can take in influencing prices, employment, and economic growth. Through this focus on economic data, students will better understand the Federal Reserve, the dynamics of the U.S. economy, and current economic conditions.]

MATERIALS


Key Economic Indicators

as of October 30, 2008

Inflation

The Consumer Price Index for All Urban Consumers (CPI-U) decreased 0.1 percent in September, before seasonal adjustment. The September level of 218.783 was 4.9 percent higher than in September 2007.

Employment and Unemployment

U.S. nonfarm payroll employment declined by 159,000 in September, and the unemployment rate held at 6.1 percent.

Real GDP

U.S. real gross domestic product decreased at an annual rate of 0.3 percent in the third quarter of 2008,(advance estimate). In the second quarter, real GDP increased 2.8 percent.

Federal Reserve

At its October 29 meeting, the Federal Open Market Committee decided to reduce the target for the federal funds rate by 1/2 percent (50 basis points) to 1.0 percent.

PROCESS

The FOMC announcement, October 29, 2008

"The Federal Open Market Committee decided today to lower its target for the federal funds rate 50 basis points to 1 percent."

The October 29 vote of the FOMC members was unanimous.

[Note to teachers: A "basis point" is 1/100 of 1 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.

Rational for a lesson 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.]

Monetary Policy Goals

Since the passage of The Employment Act of 1946 (U.S. Code Title 15 Section 1021), it has been the mandate of the federal government to "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.

As a requirement of the Employment Act of 1946, the Chairman of the Federal Reserve Board regularly testifies before Congress on the state of the economy and Federal Reserve policies. This testimony draws considerable press attention, as do many public statements by Fed board members. The press, businesses, and many in the public look for information about the direction of Fed policies between regular FOMC announcements.

In December 2003, when former Federal Reserve Chairman Allan Greenspan characterized stock market investors as "irrationally exuberant," it was widely interpreted as a negative comment about the stability of economy.

[Note to teachers: Click on this link for more about the Employment Act of 1946 , from the Federal Reserve Bank of St. Louis website.]

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. 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 The Effectiveness of Monetary Policy .

[Note to techers: For interactive student exercises about the Federal Reserve and monetary policy, go to the Fed 101 Webpage .]

The Fed Funds Rate Rollercoaster

Over the past eighteen years, a graph of the fed funds rate looks like a rollercoaster – a series of ups and downs – as the FOMC has changed the rate to expand and contract the money supply in response to changing economic conditions.

In the 1980s, the FOMC began targeting a specific level for the federal funds rate. Beginning in 1994, the FOMC began announcing its policy goals, explicitly stating the target level.

In July 1990, the fed funds rate was historically high at 8.0 percent. Over two years, seventeen 25 basis point decreases brought it down 500 basis points to 3.0 percent. In February 1994, the FOMC began increasing the rate quickly over a year to 6.0 percent in February 1995. Reversing course in July 2005, the FOMC began six years of small increases and decreases that kept the rate between 4.75 and 6.0 percent. Then, a series of 25-50 basis point decreases from January 2001 to June 2003 brought the rate steadily down.

The last time the fed funds rate was as low as 1.0 percent was in June 2003. Over the next three years, seventeen straight increases of 25 basis points brought the rate to a high of 5.25 percent in June 2006. Beginning in September 2006, nine straight rate increases, six of them being 50 or 75 basis points, have brought the rate back down to the current 1.0 percent.

Figure 1 illustrates the recent history of federal funds rate changes.

Federal Reserve Figure 1

Since February of 2000, the FOMC’s announcements have included an assessment of the risks to the achieving the long-run goals of price stability, full employment, and economic growth. The October 30 announcement expressly stated the committee's concerns about the economic downturn and crisis in financial markets.

The FOMC explanation for the October 29, 2008, monetary policy action to reduce the target for the federal funds rate:

As stated in the announcement, the FOMC members had these concerns:

  • Consumer and business spending - "The pace of economic activity appears to have slowed markedly, owing importantly to a decline in consumer expenditures. Business equipment spending and industrial production have weakened in recent months, and slowing economic activity in many foreign economies is damping the prospects for U.S. exports."
  • Continued Problems in Financial Markets - "intensification of financial market turmoil is likely to exert additional restraint on spending, partly by further reducing the ability of households and businesses to obtain credit. In light of the declines in the prices of energy and other commodities and the weaker prospects for economic activity, the Committee expects inflation to moderate in coming quarters to levels consistent with price stability."
  • Their rationale was - "Recent policy actions, including today’s rate reduction, coordinated interest rate cuts by central banks, extraordinary liquidity measures, and official steps to strengthen financial systems, should help over time to improve credit conditions and promote a return to moderate economic growth. Nevertheless, downside risks to growth remain.
  • The FOMC continues to be cautious - "The Committee will monitor economic and financial developments carefully and will act as needed to promote sustainable economic growth and price stability."

Clearly, the FOMC is concerned that the U.S. (and possibly the world) is entering or has been in a significant downturn or recession. The Bureau of Economic Analysis (BEA) announcement of real growth of U.S. gross domestic product on October 30 reinforced the FOMC's concern. The BEA's advance estimate of real GDP for the third quarter of 2008 was a .3 percent decrease.

Does the October 29 announcement reflect that the FOMC thinks the U.S. is in a recession? The direction of the fed funds rate target seems to indicate so. What do you think?

More information: A Brief Overview of the FOMC and Monetary Policy

What is the Federal Open Market Committee and how does it operate?

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 nation's 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.

For details about the FOMC and its process, go to the Federal Open Market Committee page.

The Federal Reserve has three primary tools to use to implement monetary policy.

Open Market Operations

The Federal Reserve buys and sells government securities 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 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."

Click this link for more information on Open Market Operations .

The Discount Rate

The discount rate is the interest rate the Federal Reserve charges banks if they 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.

Click on this link for for more information on The Discount Rate .

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.

Click on this link for more information on Reserve Requirements .

In addition, the Federal Reserve System has developed programs to provide greater liquidity to the banking system and to provide additional security to financial markets. They are:

  • Term Auction Facility
  • Primary Dealer Credit Facility
  • Term Securities Lending Facility
  • ABCP MMMF Liquidity Facility
  • Commercial Paper Funding Facility
  • Money Market Investor Funding Facility

For more information about these Federal Reserve monetary policy programs, visit the Federal Open Market Committee page.  Click on the links to the individual program descriptions.

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.

For more information, visit the Federal Reserve's Monetary Policy .

What works best - monetary policy or 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, 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, the 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.

Click here for more information about U.S. Fiscal Policies .

[Note to teachers: The above reference is just one chapter of a larger resource available from the U.S. Department of State, called "Outline of the U.S. Economy ." ]

CONCLUSION

Summary:

On October 29, the FOMC reduced the target for the federal funds rate to 1.0 percent, matching its lowest levels since the 1990s. In the announcement, the FOMC expressed concern that the economy's troubles are far from over.

Worsening conditions in the U.S. economy and financial markets may cause the Federal Reserve to take additional actions soon or wait until its next scheduled meeting on December 16, 2008. The Fed is a primary player in the development of plans to "bailout" weakening financial markets. New Fed programs, such as the "Term Auction Facility" and the "Money Market Investor Funding Facility" have been designed to provide financial market liquidity and security.

A St. Louis Federal Reserve Bank report on the "Effective Federal Funds Rate" indicates that the actual rate has been below 1 percent since early October. The "effective" or "actual" rate is the rate at which the overnight loans are actually made between banks. It seems like the FOMC action in October is simply recognizing what is actually taking place in the market.

[Note to teachers: To go the "Effective Federal Funds Rate " for the Federal Reserve Bank of St. Louis data.]

Targeting the fed funds rate continues to be the primary monetary policy action during these uncertain times, but may not be enough to provide the stimulus necessary to stabilize the economy. The Fed, the U.S. Treasury, and Congress have cooperated to use both monetary and fiscal policies to stimulate growth.

[NOTE: This focus on economic data s being written just prior to the November 4 elections. The outcome of the election may determine which Treasury or legislative actions are used in conjunction with Fed policies. The election will not immediately impact the Fed, but can if a new president appoints new members to the Federal Reserve Board of Governors. The new president will appoint at least two board members in the next four years, including the chairman.]

ASSESSMENT ACTIVITY

Have the students respond to these writing prompts

 

  1. What are the Federal Reserve current observations and concerns? [The FOMC believes that the economy is growing too slowly or not at all. They specifically mentioned the poor economic conditions as the reason for the October decision. There was also concern about the stability of financial markets.]

  2. If the FOMC decides to stimulate the economy, what tool will the Federal Reserve most likely use to accomplish its goals? [The Federal Reserve will seek to increase the level of economic activity (consumption and investment) by purchasing securities on the open market (open market operations). The Fed can also choose to decrease the discount rate or reduce reserve requirements. Typically, changes in the discount rate follow changes in the Fed funds rate target. Using open market operations is, by far, the more common policy tool in recent times.]

  3. The Federal Reserve uses monetary policy tools to stimulate or contract the level of economic activity. Recently, the federal government has used fiscal policies to stimulate growth. Congress voted to rebate tax revenues to U.S. tax payers. How was this strategy designed to work? [By putting more money in the hands of consumers, Congress wanted to increase the level of consumption expenditures. If people have more disposable income, they will purchase more goods and services. If people demand more goods and services, employers will hire more employees.]

  4. Given that the effective fed funds rate (the rate actually used in the market) has been consistently below the FOMC's target rate, what difference does it make when the fed announces a lower rate target? [Responses to this question will vary. Some will say that the Fed announcement is not important because it does not reflect the current reality of the market rates. Others will recognize that the announcement is a meaningful signal of the Fed's intent to impact growth and the price level and will, in fact, influence the future of the market rates. Whether the Fed's announced rate leads or follows the rate determined by the market may not matter as much as it brings the goal and reality close together.]

EXTENSION ACTIVITY

The World Interest Rates Table tracks interest rates in 23 countries around the world.

Notice that the central bank rates of most of the nations are higher - some much higher - than the U.S. rates. Students can examine the rates in the several world regions to speculate about how they relate to inflation and growth in those regions. Students can investigate the current economic conditions in the regions and how they compare and relate to currrent conditions in the U.S.