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.
The FOMC has maintained the target federal funds rate at a range of 0 to 1/4 percent since its December 16, 2008 meeting. The fed funds rate has been kept at this historically low level due to a long period of low and often negative real GDP growth, significant numbers of non-farm employment losses, and a high unemployment rate.
This lesson focuses on the September 21, 2010, press release by the Federal Open Market Committee on the current Federal Reserve monetary policy actions and goals.
NOTE: On occasion, the FOMC holds unscheduled face-to-face or conference call meetings to make more timely policy decisions in response to unusual economic events or conditions. The policy decisions made as a result of any of these unscheduled meetings will be included in the lesson on the next scheduled meeting.
- Explain the meaning of the September 21, 2010, 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.
U.S. Monetary Policy - September 21, 2010
The purpose of the Federal Reserve System's Federal Open Market Committee (FOMC) is to undertake monetary policy actions to "influence the availability and cost of money and credit to help promote national economic goals." The FOMC meets approximately every six weeks to review and recommend monetary policy goals and actions.
The nation's overall economic goals, as established by the "Employment Act of 1946," are to "promote maximum employment, production, and purchasing power." Monetary policies are intended to achieve these goals. The Federal Reserve Act of 1913 had previously given the Federal Reserve responsibility for establishing monetary policy.
The FOMC's policy statement after its September 21, 2010, meeting came just one day after the National Bureau of Economic Research (NBER) declared that the recession that began in December 2007, had ended. Without reference to a very significant or strong economic recovery, the NBER simply said that "a trough in business activity occurred in the U.S. economy in June 2009." The "trough" marks the low-point of a business cycle - in this case, a recession. The U.S. economy has seen some growth in output and employment since June, 2009, but not enough to call it a robust or strong recovery. There has been enough growth to say the recession is over and that any new decline would mark the beginning of a new recession .
The NBER cited real GDP growth and income growth since June, 2009, as evidence of the recovery. The announcement said, "the average of real GDP and real GDI was 3.1 percent above its low in the second quarter of 2009 but remained 1.3 percent below the previous peak which was reached in the fourth quarter of 2007."
The NBER waited until seeing the August 2010 data, over a year since the June 2009 trough, that confirmed the recent growth of real GDP and income. Thus, the recession ended over a year ago and a long period of slow growth seems to have begun.
Federal Open Market Committee Monetary Policy Press Release
Released: September 21, 2010
"Information received since the Federal Open Market Committee met in August indicates that the pace of recovery in output and employment has slowed in recent months. Household spending is increasing gradually, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit. Business spending on equipment and software is rising, though less rapidly than earlier in the year, while investment in nonresidential structures continues to be weak. Employers remain reluctant to add to payrolls. Housing starts are at a depressed level. Bank lending has continued to contract, but at a reduced rate in recent months. The Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, although the pace of economic recovery is likely to be modest in the near term."
The FOMC comments do not seem positive, but they are not really negative. The data indicates that things are getting better - but very slowly. This sounds much like the NBER's comments on the end of the recession. What do you think?
"Measures of underlying inflation are currently at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability. With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to remain subdued for some time before rising to levels the Committee considers consistent with its mandate."
There is no threat of inflation in the near term. What do you think?
"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 for the federal funds rate for an extended period. The Committee also will maintain its existing policy of reinvesting principal payments from its securities holdings."
The FOMC has decided to take no new policy actions - a "wait-and-see" attitude.
"The Committee will continue to monitor the economic outlook and financial developments and is prepared to provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate."
The FOMC has nine members. Eight members voted for the wording of the announcement. One member dissented.
"Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; James Bullard; Elizabeth A. Duke; Sandra Pianalto; Eric S. Rosengren; Daniel K. Tarullo; and Kevin M. Warsh."
"Voting against the policy was Thomas M. Hoenig, who judged that the economy continues to recover at a moderate pace. Accordingly, he believed that continuing to express the expectation of exceptionally low levels of the federal funds rate for an extended period was no longer warranted and will lead to future imbalances that undermine stable long-run growth. In addition, given economic and financial conditions, Mr. Hoenig did not believe that continuing to reinvest principal payments from its securities holdings was required to support the Committee’s policy objectives."
Introduction to The Federal Reserve System, the FOMC, and Monetary Policy
The Federal Reserve System was created by Congress in 1913 "to provide the nation with a safer, more flexible, and more stable monetary and financial system." It is a federal system, composed of a central, governmental agency, the Board of Governors, in Washington, D.C., and twelve regional Federal Reserve Banks, located in major cities throughout the nation.
The Federal Reserve’s duties fall into four general areas:
- Conducting the nation’s monetary policy by influencing monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates.
- Supervising and regulating banking institutions to ensure the safety and soundness of the nation’s banking and financial system and to protect the credit rights of consumers.
- Maintaining the stability of the financial system and containing systemic risk that may arise in financial markets.
- Providing financial services to depository institutions, the U.S. government, and foreign official institutions, including playing a major role in operating the nation’s payments system.
A Brief History of Central Banks
Most developed countries have a central bank whose functions are broadly similar to those of the Federal Reserve. The oldest, Sweden’s Riksbank, has existed since 1668 and the Bank of England since 1694. Napoleon I established the Banque de France in 1800, and the Bank of Canada began operations in 1935. The German Bundesbank was reestablished after World War II and is loosely modeled on the Federal Reserve. More recently, some functions of the Banque de France and the Bundesbank have been assumed by the European Central Bank, formed in 1998.
The Creation of the Federal Reserve System
During the nineteenth century and the beginning of the twentieth century, financial panics plagued the nation, leading to bank failures and business bankruptcies that severely disrupted the economy. The failure of the nation’s banking system to effectively provide funding to troubled depository institutions contributed significantly to the economy’s vulnerability to financial panics. After the crisis of 1907, Congress established a commission and institution that would help prevent and contain financial disruptions.
Congress passed the Federal Reserve Act in “to provide for the establishment of Federal reserve banks, to furnish an elastic currency, to afford means of re-discounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes.” President Woodrow Wilson signed the act into law on December 23, 1913.
The twelve regional Federal Reserve Banks and their Branches carry out a variety of System functions, including operating a nationwide payments system, distributing the nation’s currency and coin, supervising and regulating member banks and bank holding companies, and serving as banker for the U.S. Treasury. The twelve Reserve Banks are each responsible for a particular geographic area or district of the United States. Each Reserve District is identified by a number and a letter. Besides carrying out functions for the System as a whole, such as administering nationwide banking and credit policies, each Reserve Bank acts as a depository for the banks in its own District and fulfills other District responsibilities.
|Federal Reserve Bank Districts|
|2||B||New York, New York|
|8||H||St. Louis, Missouri|
|10||J||Kansas City, Missouri|
|12||L||San Francisco, California|
The Federal Reserve Board of Governors
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 current chairman of the Federal Reserve is Ben S. Bernanke, Ph.D. Dr. Bernanke was sworn in on February 1, 2006, as Chairman and a member of the Board of Governors of the Federal Reserve System. Dr. Bernanke also serves as Chairman of the Federal Open Market Committee. He was appointed as a member of the Board to a full 14-year term, which expires January 31, 2020, and to a four-year term as Chairman. He was reappointed for four years as chairman, as of February 1, 2010. Before his appointment as Chairman, Dr. Bernanke had been Chairman of the President's Council of Economic Advisers, from June 2005 to January 2006.
The Federal Open Market Committee (FOMC)
An important component of the Federal Reserve System is the Federal Open Market Committee (FOMC), which is made up of the members of the Board of Governors, the president of the Federal Reserve Bank of New York, and presidents of four other Federal Reserve Banks, who serve on a rotating basis. The FOMC oversees open market operations, which is the main tool used by the Federal Reserve to influence money market conditions and the growth of money and credit. Traditionally, the Chairman of the Board of Governors serves as the Chairman of the FOMC.
Federal Reserve Policy Tools
The Federal Reserve implements monetary policy through its control over the federal funds rate, the rate at which depository institutions trade balances at the Federal Reserve. It exercises this control by influencing the demand for and supply of these balances through the following means:
- Open market operations: the purchase or sale of securities, primarily U.S. Treasury securities, in the open market to influence the level of balances that depository institutions hold at the Federal Reserve Banks. Open market operations are used to meet the goal of the target federal funds rate. Open market operations are conducted by the Domestic Trading Desk at the Federal Reserve Bank of New York.
- Reserve requirements: requirements regarding the percentage of certain deposits that depository institutions must hold in reserve in the form of cash or in an account at a Federal Reserve Bank.
- Contractual clearing balances: an amount that a depository institution agrees to hold at its Federal Reserve Bank in addition to any required reserve balance.
- Discount window lending (discount rate): extensions of credit to depository institutions made through the primary, secondary, or seasonal lending programs.
By trading government securities, the New York Fed affects the federal funds rate, which is the interest rate at which depository institutions lend balances to each other overnight. The Federal Open Market Committee establishes the target rate for trading in the federal funds market. The target rate is currently set at a 0 to 1/4 percent range (since December, 2008.)
Figure 1 shows the recent history of the target federal funds rate through current period. Notice how the target rate has normally moved up and down in a cyclical pattern. This pattern of change is strongly correlated with the business cycles, generally increasing during expansionary periods and decreasing during contractions. The fed funds rate target has been set at 0 to 1/4 percent since December 2008.
How Monetary Policy Affects the Economy
The initial link in the chain between monetary policy and the economy is the market for balances held at the Federal Reserve Banks. Depository institutions have accounts at their Reserve Banks, and they actively trade balances held in these accounts in the federal funds market at an interest rate known as the federal funds rate. The Federal Reserve exercises considerable control over the federal funds rate through its influence over the supply of and demand for balances at the Reserve Banks.
The FOMC sets the federal funds rate at a level it believes will foster financial and monetary conditions consistent with achieving its monetary policy objectives, and it adjusts that target in line with evolving economic developments. A change in the federal funds rate, or even a change in expectations about the future level of the federal funds rate, can set off a chain of events that will affect other short-term interest rates, longer-term interest rates, the foreign exchange value of the dollar, and stock prices. In turn, changes in these variables will affect households’ and businesses’ spending decisions, thereby affecting growth in aggregate demand and the economy.
Short-term interest rates, such as those on Treasury bills and commercial paper, are affected not only by the current level of the federal funds rate but also by expectations about the overnight federal funds rate over the duration of the short-term contract. As a result, short-term interest rates could decline if the Federal Reserve surprised market participants with a reduction in the federal funds rate, or if unfolding events convinced participants that the Federal Reserve was going to be holding the federal funds rate lower than had been anticipated. Similarly, short-term interest rates would increase if the Federal Reserve surprised market participants by announcing an increase in the federal funds rate, or if some event prompted market participants to believe that the Federal Reserve was going to be holding the federal funds rate at higher levels than had been anticipated.
Expansionary monetary policy actions: Decrease interest rates
- Reduce the target fed funds rate
- Open market operations: buy securities
- Reduce reserve requirements
- Decrease the discount rate
Contractionary monetary policy actions: Increase interest rates
- Increase the target fed funds rate
- Open market operations: sell securities
- Increase reserve requirements
- Increase the discount rate
Changes in short-term interest rates will influence long-term interest rates, such as those on Treasury notes, corporate bonds, fixed-rate mortgages, and auto and other consumer loans. Long-term rates are affected not only by changes in current short-term rates but also by expectations about short-term rates over the rest of the life of the long-term contract. Generally, economic news or statements by officials will have a greater impact on short-term interest rates than on longer rates because they typically have a bearing on the course of the economy and monetary policy over a shorter period; however, the impact on long rates can also be considerable because the news has clear implications for the expected course of short-term rates over a longer time period.
In the current economic environment, negative GDP growth, decreasing employment, and lack of adequate credit, the Fed has adopted a stimulatory policy. Given the very low level of interest rates, over the last year, the Federal Reserve has taken additional measures to open up financial markets and stimulate spending.
The Federal Reserve established several new programs to counter the "liquidity crisis" and the tight credit markets. These programs are intended to provide capital to different types of financial institutions "to strengthen market stability, improve the strength of financial institutions, and enhance market liquidity. Most of these special program have been ended or "wound down" in the past year.
The first of these new Fed programs was the Term Auction Facility (TAF), created to improve bank liquidity. The TAF "allows a depository institution to place a bid for an advance from its local Federal Reserve Bank at an interest rate that is determined as the result of an auction. By allowing the Federal Reserve to inject term funds through a broader range of counterparties and against a broader range of collateral than open market operations, this facility could help ensure that liquidity provisions can be disseminated efficiently even when the unsecured interbank markets are under stress."
Click on the links to find out more about each program's purpose and specific goals:
- Term Auction Facility (TAF)
- Primary Dealer Credit Facility (PCDF)
- Term Securities Lending Facility (TSLF)
- Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (ABCP MMMF)
- Commercial Paper Funding Facility (CPFF)
- Money Market Investor Funding Facility (MMIFF)
- Term Asset-Backed Securities Loan Facility (TALF)
The common thread in these Fed programs' goals is to improve the balance sheets of financial institutions by supporting the value of their assets. One of the problems with bank holding has been uncertainty about the underlying value of the securities they hold. By replacing the banks' securities, such as mortgaged-backed securities, with those with more secure values, confidence in the banks will increase. In a more stable market with more predictable asset values, more narrowing and lending should result.
The Fed has the capacity to revive these programs should economic conditions or banking system instability reoccur.
Again, the Federal Open Market Committee decided to keep the federal funds rate target at a historic low of 0 to 1/4 percent in order to encourage economic activity, spending and investment. The Fed funds rate infleunces othe interest rates to move in the direction of the Fed policy. In this case, no change was taken because interet rates are already very low.
If lower interest rates cannot be used to stimulate the economy, what will? Is it now just a crisis of confidence - banks not confident enough to make loans, consumers not confident enough to borrow, and employers nt confident enough to hire?
The NBER declared that the recession ended in June, and agreed with the FOMC that the recovery will be slow. At 9.6 percent, U.S. unemployment remains very high by historical standards. Are jobs the key to a real recovery?
Next, answer the essay question below on the interactive notepad.
1. During a recessionary period, why would the Federal Reserve and FOMC choose to keep interest rates low?
2. How do low interest rates help to achieve the Fed's goal to stimulate the economy and help banks?
Take a look at data about your school's regional Federal Reserve district bank. 12 regional Federal Reserve Banks serve the United States.
From the Map of the Twelve Federal Reserve System Districts , students should identify the Federal Reserve Bank that serves their school's geographic area.
Students can explore their Federal Reserve Bank's web site for information about the economic health of their region and programs available to area businesses and consumers.
- Are economic conditions in your region of the United States similar, better or worse than national economic conditions? Growth? Employment/unemployment? Price level changes?
- Are there any particular characteristics about your region that impact it's economic health - better or worse than other regions?
- What do the president and/or other leaders of your Federal Reserve Bank have say about current regional economic conditions?
- What programs and information services does your Federal Reserve Bank offer to businesses, consumers or schools?
Take another look at the map of the regional Federal Reserve Banks. Do the sizes and boundaries of the twelve regions make sense to you? Remember, this map was drawn in 1913 when the population and level of economic activity of the western and southern regions was very much smaller.
Do you think the map would look different if the regions were established and the map was drawn today?