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INTRODUCTION

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 over a year of low and often negative real GDP growth, significant numbers of non-farm employment losses and very high unemployment.

This lesson focuses on the April 28, 2010, press release by the Federal Open Market Committee on the current Federal Reserve monetary policy actions and goals.

TASK

  • Explain the meaning of the December 14, 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.
  • identify the current actions taken by the Federal Reserve to achieve its monerary policy goals.
  • Exlain the intended effects of open market operations.

PROCESS

December, 2010, marks two significant anniversaries related to the current economic cycle.

  • On December 1, 2008, The National Bureau of Economic Research (NBER) declared that the U.S. economy reached a peak in the business cycle in December, 2007, and the most recent recession began. The NBER later declared the recession over as of June, 2009.
     
  • At its December 8, 2008, meeting, the Federal Open Market Committee established the target for the federal funds rate at a range of 0 to 1/4 percent.  This historically low fed funds rate target has been maintained at this level to this time.

What did the FOMC have to say, two years after pushing it's primary tool to reduce interest rates and stimulate credit markets - the federal funds rate - to it's low limit?

Remember, the primary monetary policy goals of the Federal Reserve, as established by the Employment Act of 1946, are to "promote maximum employment, production, and purchasing power."  In other words, policies should create jobs (reduce unemployment), increase output, and keep the price level stable.

Federal Open Market Committee “Monetary Policy” Statement
Released: December 14, 2010

The FOMC said, "Information received since the Federal Open Market Committee met in November confirms that the economic recovery is continuing, though at a rate that has been insufficient to bring down unemployment."

Things are getting better, but not enough to put people back to work, earning income and spending on goods and services.  Still, the FOMC press release focuses initially on the prospects for economic recovery.

Is this a good sign or a bad one?  Is the high unemployment rate a better sign of the health (or lack of) of the economy than GDP growth?   Figures 1 and 2, below, show the recent history of the U.S. unemployment rates and real GDP growth.

Figure 1

Figure 2

How can U.S. output be increasing and yet the unemployment rate remains very high?  There are many factors influencing the growth and unemployment rates (size of the labor force, number marginal workers, etc.), but one key factor in the past year has been a significant increase in the rate of labor productivity - the amount of output per hour worked.

Look at the annual rates of productivity increases in recent years, below.    U.S. labor productivity increased at an annual rate of 3.5 percent in 2009 as U.S. real GDP growth became positive and the NBER declared the e recession over.   What happened to the unemployment rate during this time?  Take a look back at Figure 1.
 

Year Labor Productivity
Rate Change
2006 0.9
2007 1.6
2008 1.0
2009 3.5
2010 (Q3) 2.3


The FOMC said, "Household spending is increasing at a moderate pace, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit."

Normally, a "moderate pace" of increased spending sounds okay, but the FOMC says it is not enough.  Too many people are out of work and not earning enough income to make a difference and too uncertain about their futures. 

The October 10, 2010, BLS report on consumer spending for the year 2009:

Consumer Expenditures  - 2009

"Average annual expenditures per consumer unit(1) fell 2.8 percent in 2009 following an increase of 1.7 percent in 2008, according to results from the Consumer Expenditure Survey (CE) released by the U.S. Bureau of Labor Statistics. The spending decrease was larger than the 0.4-percent decrease in prices from 2008 to 2009 as measured by the average annual change in the Consumer Price Index (CPI-U). This was the first time there has been a drop in spending from the previous year since the CE began publishing integrated data in 1984 from the Diary and Interview components of the CE."              

"Spending on housing and transportation fell 1.3 percent and 11.0 percent, respectively, contributing to the overall drop in spending in 2009. Healthcare expenditures rose 5.0 percent, the only increase among the major components of spending. Among the other major components, food dropped 1.1 percent, apparel fell 4.2 percent, entertainment dropped 5.0 percent, and personal insurance and pensions fell 2.4 percent."

Consumers are not carrying their share of the load in stimulating the economy.  Why?  What would cause people to cut back on their consumption?  High unemployment? Uncertainty about the future? 

[NOTE: Unfortunately, full figures for consumer spending in year 2010 are not available at this time.  The BEA does note in the data for November, 2010, that personal consumption expenditures (PCE) has increased in the last half of 2009 and in 2010, after significant decreases in  2008 and early 2009.]

The FOMC said, "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."

The FOMC also said, "Employers remain reluctant to add to payrolls."

Businesses are not investing in new capital at this time as much as in the recent past. Business investment should be an indicator of future growth and employment.  What happens when businesses do not invest?  Can they create now jobs?  Can they increase output?  

The FOMC said, "The housing sector continues to be depressed."

Remember, consumer purchases of new housing is counted as "investment."    Consumers  remain reluctant to invest in new homes, as weakness that has plagued the U.S. economy for several years.  The uncertainty stemming from the "housing crisis," the "banking crisis," and the "credit crunch" remains and strongly influences consumers' behavior.

Good news!  There seems to be little chance of inflation in the near term.

The FOMC said, "Longer-term inflation expectations have remained stable, but measures of underlying inflation have continued to trend downward."  Figure 3, below, shows the monthly rates of change of the CPI-U in recent years.   Note the very low annual rates of inflation during the period of the recession. 

[NOTE: This looks a lot like the "Phillips Curve," the traditional theory that you should not have high unemployment and inflation at the same time - or vise versa.  The 1980's and 1990's proved that unemployment and inflation are not clearly correlated in this sense. We have had periods of both high unemployment and high inflation.  And, we have had periods of both measurements being low.] 

Figure 3

If you leave out the highly volatile energy (especially gasoline) prices over this time period, there has been very little inflation and occasionally some concern about the prospects for deflation.

Are you worried about inflation?

What did the FOMC decide to do at its December 14 meeting?

The FOMC confirmed its legal mandate in the next paragraph of the press release.  The FOMC statement said, "Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. Currently, the unemployment rate is elevated, and measures of underlying inflation are somewhat low, relative to levels that the Committee judges to be consistent, over the longer run, with its dual mandate. Although the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, progress toward its objectives has been disappointingly slow."

Again, the unemployment rate remains too high and inflation is not a concern. What can the Fed do when the economic recovery is "disappointingly slow."

FOMC Policy Actions

Purchasing Securities: "To promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to continue expanding its holdings of securities as announced in November. The Committee will maintain its existing policy of reinvesting principal payments from its securities holdings. In addition, the Committee intends to purchase $600 billion of longer-term Treasury securities by the end of the second quarter of 2011, a pace of about $75 billion per month. The Committee will regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed to best foster maximum employment and price stability."

When the Fed purchases securities through open market operations, it expands the banking system's capacity to make loans and interest rates are influenced downward. With more money to lend at lower interest rates, this should have a stimulatory impact on the economy.  With low rates, businesses should increase investment and hire more workers.  Consumers should increase purchasing with credit.

So far in 2010, these programs have not had the desired effect, at least to the extent desired by the Fed.  The FOMC statement expressed some concern that these policies may have a negative impact on price stability at some point, so they are ready to "adjust" the program as needed.

Federal Funds Rate: "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 FOMC voted for no change in the fed funds rate.  Figure 4, below, shows the history of the federal funds rate over the past several years.  The current rate, set in December, 2008, is a historic low, but has not been enough to encourage the desired level of economic activity."

Figure 4

The FOMC statement added, "The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to support the economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate."

The vote for this policy statement was almost unanimous, with just one dissenting vote by Thomas M. Hoenig, President of the Federal Reserve Bank of Kansas City.  As he has also expressed in recent meetings, Mr. Hoenig is, "concerned that a continued high level of monetary accommodation would increase the risks of future economic and financial imbalances and, over time, would cause an increase in long-term inflation expectations that that could destabilize the economy."

CONCLUSION

What more can the Federal Reserve, Congress, the President, or other government agencies do to get the economy moving at a faster pace and create jobs for the millions of unemployed?

The Fed has kept the fed funds rate target historically low, influencing other rates to remain low - mortgage rates, consumer loans, auto loans, etc.  The Fed is purchasing securities to provide additional financial market liquidity.  

Interest rates are not the issue.  Uncertainty about the future and, perhaps, caution not to make the same mistakes may be keeping banks from lending, businesses from hiring and, consumers from purchasing.  

The Fed's policy statement provides little real hope of improvement in growth of output and employment.  The recession over, but the impact remains and true recovery is slow?

Congress and President Obama seem to have agreed on a package of corporate and individual tax cut extensions, unemployment compensation extensions, and further stimulus policies to weather the storm, but at a very high price to be paid in the future.

ASSESSMENT ACTIVITY

Next, complete the essay question below on the interactive notepad. 


1. What is the purpose of the FOMC's target for the federal funds rate?

EXTENSION ACTIVITY

The Federal Reserve Bank of Philadelphia has published a new online activity called The Case of the Gigantic $100,000 Bill.   In this lesson, students participate in a demonstration of the money creation process using a large $100,000 bill. Expansions of the money supply caused by successive deposits and loans are traced on the board so that students can observe the process. Students learn to calculate the upper bound of the money creation process using the simple money multiplier.