The Federal Open Market Committee (FOMC) of the Federal Reserve System (Fed) meets approximately every six weeks to determine the nation's monetary policy goals and, specifically, to set the target for the federal funds rate (fed funds rate). The fed funds rate is the interest rate at which banks lend their balances at the Federal Reserve to other banks, usually overnight.
This lesson focuses on the November 11, 2009, press release by the Federal Open Market Committee on the current Federal Reserve monetary policy actions and goals.
- Explain the meaning of the March 18, 2009 Federal Open Market Committee decision concerning the target for the federal funds rate.
- Identify the current monetary policy goals of the Federal Reserve and the factors that have recently influenced monetary policy goals.
- Explain the structure and functions of the Federal Reserve System, Federal Reserve Banks, and the Federal Open Market Committee.
- Identify the monetary policy options and other tools available to the Federal Reserve to stimulate or contract the economy.
Federal Reserve System Monetary Policy Press Release, November 4, 2009
The FOMC opened the November 4, 2009, Monetary Policy announcement by acknowledging that economic conditions are improving, but that problems in financial markets continue. The Committee also acknowledged that efforts to stabilize financial markets and stimulate the economy must continue for some time. It clearly stated that the prospects for inflation are very low.
"Information received since the Federal Open Market Committee met in September suggests that economic activity has continued to pick up. Conditions in financial markets were roughly unchanged, on balance, over the intermeeting period. Activity in the housing sector has increased over recent months. Household spending appears to be expanding but remains constrained by ongoing job losses, sluggish income growth, lower housing wealth, and tight credit. Businesses are still cutting back on fixed investment and staffing, though at a slower pace; they continue to make progress in bringing inventory stocks into better alignment with sales. Although economic activity is likely to remain weak for a time, the Committee anticipates that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will support a strengthening of economic growth and a gradual return to higher levels of resource utilization in a context of price stability."
"With substantial resource slack likely to continue to dampen cost pressures and with longer-term inflation expectations stable, the Committee expects that inflation will remain subdued for some time."
The announcement confirmed what most economists and commentators expected, no change in the federal funds rate target. With no anticipation of inflationary pressures, the FOMC decided that low interest rates are appropriate and that programs to support mortgage lending and credit markets will continue.
"In these circumstances, the Federal Reserve will continue to employ a wide range of tools to promote economic recovery and to preserve price stability. The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period. To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve will purchase a total of $1.25 trillion of agency mortgage-backed securities and about $175 billion of agency debt. The amount of agency debt purchases, while somewhat less than the previously announced maximum of $200 billion, is consistent with the recent path of purchases and reflects the limited availability of agency debt. In order to promote a smooth transition in markets, the Committee will gradually slow the pace of its purchases of both agency debt and agency mortgage-backed securities and anticipates that these transactions will be executed by the end of the first quarter of 2010. The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets. The Federal Reserve is monitoring the size and composition of its balance sheet and will make adjustments to its credit and liquidity programs as warranted."
The Committee action was unanimously approved. "Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Donald L. Kohn; Jeffrey M. Lacker; Dennis P. Lockhart; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen."
The November 6, 2009, announcement by the BLS that the U.S. unemployment rate had increased in October to 10.2 percent underscores the Fed's concern about the state of the economy and the need for further stimulus facilitated by low interest rates. Unemployment typically is a lagging economic indicator - not indicating further future problems, but telling us that things have not improved as much as had been hoped. The significant increase in unemployment in October has cause many to think that the economic recovery may take longer and that even higher unemployment may come in the following months.
Figure 1, below, shows the recent history of the target federal funds rate. Note the exceptionally low rate (range of 0-1/4 percent) that has been in effect since December 2008.
Open Market Operations
Open market operations are the Federal Reserve's primary tool for implementing monetary policy. The Fed web page briefly explains the objective of open market operations. "Open market operations--purchases and sales of U.S. Treasury and federal agency securities--are the Federal Reserve's principal tool for implementing monetary policy. The short-term objective for open market operations is specified by the Federal Open Market Committee (FOMC). This objective can be a desired quantity of reserves or a desired price (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."
The Federal Reserve's objective for Open Market Operations has varied over the years.. During the 1980s, the focus gradually shifted toward attaining a specified level of the federal funds rate, a process that was largely complete by the end of the decade. Beginning in 1994, the FOMC began announcing changes in its policy stance, and in 1995 it began to explicitly state its target level for the federal funds rate. Since February 2000, the statement issued by the FOMC shortly after each of its meetings usually has included the Committee's assessment of the risks to the attainment of its long-run goals of price stability and sustainable economic growth.”
With the target range for the federal funds rate at such a low level and the real rate exceptionally low, there is not much potential for use of the typical monetary policy tools to stimulate growth. The Fed has made unprecedented efforts to stabilize credit markets, improve liquidity and encourage lending.
Bank Reserves and the Fed Funds Rate
Banks are required by law to keep some of their reserves in an account with Federal Reserve or as cash in their vaults. The required reserve level is determined by their outstanding assets and liabilities and the minimum level set by the Fed - typically equal to about 10% of their demand accounts. The actual requirement can vary by the size of the bank. Any reserves beyond the minimum requirement are “excess reserves” that are available to make loans.
When a bank makes a loan, its reserves decrease. If its reserves drop below the required minimum, it must accumulate additional reserves to meet the Fed’s requirement. The bank can borrow the needed funds from another bank that has a surplus of (excess) reserves. The interest rate a bank pays when it borrow funds from another bank is negotiated between the two banks. The average of these negotiated rates is the effective federal funds rate.
The target federal funds rate set by FOMC is maintained through open market operations. By purchasing or selling securities, the Fed can influence the level of bank reserves, and thus, the level of the federal funds rate. The FOMC will increase or decrease the target rate depending on economic conditions and the Fed’s overall monetary policy goals. The Fed doesn’t actually set the rate, but can influence the rate through open market operations. When a bank buys securities, from the Fed, it then has fewer funds to loan. When a bank sells securities to the Fed, it then has more funds (reserves) to loan.
An alternative for banks that must increase their reserves is to borrow directly from the Federal Reserve through the “discount window.” The discount rate is typically slightly higher than the federal funds rate. The FOMC will typically set the discount rate as it establishes a target for the federal funds rate.
What Happens at a FOMC Meeting?
After each FOMC meeting and announcement, the meeting minutes are prepared and released about three weeks later. The minutes often provide insight into the focus of the meeting and the factors that influenced the FOMC decision. The minutes contain staff reports and committee discussion. As an example, the minutes of the September 22-23, 2009, FOMC meeting contained these staff comments on economic conditions at that time.
“Factory output, particularly motor vehicle production, rose in July and August. Consumer spending on motor vehicles during that period was boosted by government rebates and greater dealer incentives, and household spending outside of motor vehicles appeared to rise in August after having been roughly flat from May through July. Although employment continued to contract in August, the pace of job losses slowed noticeably from that of earlier in the year. Investment in equipment and software (E&S) also seemed to be stabilizing. Sales and construction of single-family homes during July and August, while still at low levels, were significantly above the readings at the beginning of the year. The sharp cuts in production this year reduced inventory stocks significantly, though they remained elevated relative to the recent level of sales. Core consumer price inflation continued to be subdued in July and August, but higher gasoline prices raised overall consumer price inflation in August.”
The FOMC relies on the research staff to assess current conditions and suggest the impact in the future. In this case, the staff report cited improving output but continued low levels of output. The staff looks at a variety of economic data, paying particular attention to output, employment and price level.
”In the United States, core consumer price inflation remained subdued in July and August, as price increases in housing services moderated and durable goods prices declined. Overall consumer price inflation increased in August, boosted by a sharp upturn in energy prices, particularly those of gasoline. The latest available survey data indicated that gasoline prices edged up further in the first half of September. Consumer food prices were little changed in August.”
“In the forecast prepared for the September FOMC meeting, the staff raised its projection for real GDP growth over the second half of 2009 and over 2010. The information received during the intermeeting period appeared to indicate a more noticeable upturn than anticipated at the time of the August meeting: Sales and starts of single-family homes provided evidence of some firming in housing activity, capital spending indicators pointed to an earlier-than-anticipated trough for investment in E&S, and some data suggested a modest recovery in consumer spending. These tentative signs of a recovery of economic activity were supported by other factors, including recent rises in house and equity prices that would support household net worth, declines in interest rates on corporate bonds and fixed-rate mortgages, and a stronger outlook for activity in foreign economies.”
The staff report is followed by discussion among the FOMC members about their assessments of their regions’ economic health. “In their discussion of the economic situation and outlook, meeting participants agreed that the incoming data and information received from business contacts suggested that economic activity had picked up following its severe downturn; most thought an economic recovery was under way. Many participants noted that since August, they had revised up their projections for the second half of 2009 and for subsequent years.”
After the discussion of regional conditions and assessment of the staff reports, the committee makes a recommendation for monetary policy. In September, the FOMC concluded, “In their discussion of monetary policy for the period ahead, Committee members agreed that no significant changes to its policy target rate or large-scale asset purchase programs were warranted at this meeting. Although the economic outlook had improved further in recent weeks and the risks to the forecast had become more balanced, the level of economic activity was likely to be quite weak and resource utilization low. With substantial resource slack likely to persist and longer-term inflation expectations stable, the Committee anticipated that inflation would remain subdued for some time. Under these circumstances, the Committee judged that the costs of growth turning out to be weaker than anticipated could be relatively high. Accordingly, the Committee agreed that it was appropriate to maintain its target range for the federal funds rate at 0 to 1/4 percent and to reiterate its view that economic conditions were likely to warrant an exceptionally low level of the federal funds rate for an extended period.”
The meeting minutes, released several weeks after the meeting provide additional insight into the meaning of the FOMC initial statement and the factors that influenced their policy action.
Fed Response to the Financial Crisis
The Federal Reserve has designed a variety of new programs (the Fed calls them tools) beyond the traditional monetary policy tools in response to the current financial crisis. The Fed web site explains, "The Federal Reserve has responded aggressively to the financial crisis since its emergence in the summer of 2007. The reduction in the target federal funds rate from 5-1/4 percent to effectively zero was an extraordinarily rapid easing in the stance of monetary policy. In addition, the Federal Reserve has implemented a number of programs designed to support the liquidity of financial institutions and foster improved conditions in financial markets. These new programs have led to a significant change to the Federal Reserve’s balance sheet."
"The first set of tools, which are closely tied to the central bank's traditional role as the lender of last resort, involve the provision of short-term liquidity to banks and other financial institutions. Because bank funding markets are global in scope, the Federal Reserve has also approved bilateral currency swap agreements with 14 foreign central banks. These swap arrangements assist these central banks in their provision of dollar liquidity to banks in their jurisdictions.
A second set of tools involve the provision of liquidity directly to borrowers and investors in key credit markets. The Commercial Paper Funding Facility, the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, the Money Market Investor Funding Facility, and the Term Asset-Backed Securities Loan Facility fall into this category. All of the programs are described in detail elsewhere on this website.
As a third set of instruments, the Federal Reserve has expanded its traditional tool of open market operations to support the functioning of credit markets through the purchase of longer-term securities for the Federal Reserve's portfolio. For example, on November 25, 2008, the Federal Reserve announced plans to purchase up to $100 billion in government-sponsored enterprise (GSE) debt and up to $500 billion in mortgage-backed securities. On March 18, the Federal Reserve announced plans to purchase up to $300 billion of longer-term Treasury securities in addition to increasing its total purchases of GSE debt and mortgage-backed securities to up to $200 billion and $1.25 trillion, respectively."
The Fed and the U.S. Treasury are creating ways to support financial institutions by finding ways to buy or guarantee the value of so-called "toxic assets." These include hundreds of billions of dollars of mortgage backed securities that banks hold but are difficult, if not impossible, to sell in the current market conditions. By replacing the "toxic assets" on bank balance sheets with more liquid assets, the banks will be more able to engage in their primary activity - lending.
Some Key Terms From the Federal Reserve Monetary Policy Announcement
Fixed investment in refers to investment in fixed capital, capital used for production or residential buildings, or to the replacement of depreciated capital goods. (machinery, land, buildings, installations, vehicles, or technology)
Inventory consists of raw materials, work-in-process goods, and finished goods that are a business's assets that are ready or will be ready for sale. The sale of inventory is a source of revenue and earnings for the company.
Resource utilization – the Fed report referred to low rates of resource utilization. This represents the output gap, or the difference between actual and potential GDP when resources, primarily labor and capital, are not being use to their full capacity.
You may also hear the term “capacity utilization.” This refers to percentage of the economy's total plant and equipment that is currently in production. Usually, a decrease in this percentage signals an economic slowdown, while an increase signals economic expansion
Agency debt is a security, usually a bond, issued by a U.S. government-sponsored agency. The offerings of these agencies are backed by the government, but not guaranteed by the government since the agencies are private entities. Some prominent issuers of agency securities are Student Loan Marketing Association (Sallie Mae), Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac).
Mortgage-backed securities are assets backed security or debt obligations that represents a claim on the cash flows from mortgage loans, most commonly on residential property. Mortgage loans are purchased from banks, mortgage companies, and other originators, and then are assembled into pools. The securities are usually sold as bonds, but financial innovation has created a variety of securities that derive their ultimate value from mortgage pools.
Balance sheet refers to a financial statement of the assets, liabilities and net worth of an individual or organization on a given date. The Federal Reserve has “balance sheet” consisting of its assets and liabilities. The Fed’s balance sheet has grown as it has accumulated assets, such as mortgage-backed securities, from financial institutions.
These definitions are taken from various Federal Reserve publications and online resources. For more definitions of key Federal Reserve, banking and financial terms, go to the Federal Reserve Education Glossary of Terms .
In keeping with the policy decisions of the past year, the FOMC kept the target rate range for the federal funds rate at 0 to .25 percent. The FOMC's rationale was similar to recent announcements, yet providing some hoe that there has been some improvement in the U.S. economy.
One question often discussed among economists and financial professionals is when the Fed will reverse course and increase the fed funds rate - with the goal of increasing interest rates. Most agree that signs of inflationary pressures will cause the FOMC to raise rates. The FOMC has made it clear that little inflationary pressure currently exists. Resource utilization is low and resource prices are stable if not decreasing.
Energy prices may be the wide card, as oil prices have recently increased. If energy demand is a result of growth, the FOMC may anticipate more broad inflationary pressures. If other prices do not follow energy, the FOMC may not see the need to raise rates. Watch energy prices and the overall rate of inflation (CPI-U) in the coming months.
Next, answer the essay question on the interactive notepad below.
1. What is the purpose of the FOMC's target for the federal funds rate?
The Federal Reserve has published a web-based resource for teachers and students called "Federal Reserve Education
Federal Reserve Education includes sections on the history of the Fed, the structure of the Fed, monetary policy, bank supervision, and financial services.
- Click on the link to "Monetary Policy." Click on the link and review the "Basics of Monetary Policy."
- Click on "How does the Fed create money?" to learn how Fed actions can influence the money supply.
- Click on "Economic Indicators" to review the meaning of gross domestic product, consumer price index, unemployment rate and other economic indicators.
This will help you better understand the monetary policy goals and actions of the Fed in the context of economic conditions, such as those discussed at the FOMC meetings.
Federal Reserve Education includes a link to a web page that lists key National Economic Indicators and additional links to the current data for each indicator.