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A CASE STUDY
The Federal Reserve System and Monetary Policy
The Federal Open Market Committee
Date of Announcement
December 9, 2003
Dates of Future Federal Open Market Committee Meetings
January 27 and 28, 2004
Target
federal funds
rate is
1.0 percent
Target federal
funds rate has
not changed in
the last four
meetings
The
discount
rate is 2.0
percent
The Announcement
The Federal Open Market Committee decided today to keep its
target for the federal funds rate at 1 percent.
The Committee continues to believe that an accommodative stance
of monetary policy, coupled with robust underlying growth in
productivity, is providing important ongoing support to economic
activity. The evidence accumulated over the intermeeting period
confirms that output is expanding briskly, and the labor market
appears to be improving modestly. Increases in core consumer
prices are muted and expected to remain low.
The Committee perceives that the upside and downside risks to the
attainment of sustainable growth for the next few quarters are
roughly equal. The probability of an unwelcome fall in inflation
has diminished in recent months and now appears almost equal to
that of a rise in inflation. However, with inflation quite low and
resource use slack, the Committee believes that policy
accommodation can be maintained for a considerable period.
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Voting for the FOMC monetary policy action were: Alan
Greenspan, Chairman; Timothy F. Geithner, Vice Chairman; Ben
S. Bernanke; Susan S. Bies; J. Alfred Broaddus, Jr.; Roger W.
Ferguson, Jr.; Edward M. Gramlich; Jack Guynn; Donald L. Kohn;
Michael H. Moskow; Mark W. Olson; and Robert T. Parry.
This press release is available at:
http://www.federalreserve.gov/BoardDocs/Press/monetary/2003/20031
209/
Reasons for a Case Study on the Federal Open Market Committee
(FOMC)
The target federal funds rate is at a record low as the Federal Reserve
monetary policy committee has concerned itself with encouraging the
recovery from the 2001 recession and the possibility of experiencing a
deflationary period. Recent announcements reflect serious concerns with
the state and direction of the economy. The recession is over; concern
with the possibility of deflation is reduced; growth in spending and
employment has not yet reached robust levels; and yet some observers are
beginning to discuss the possibilities of higher interest rates in the near
future.
This case study is intended to guide students and teachers through an
analysis of the actions the Federal Reserve began to take in January of
2001 in efforts to strengthen the economy. An understanding of monetary
policy in action is fundamental to developing a thorough understanding of
macroeconomics and the U.S. economy.
Notes to Teachers
The material in this case study in italics is not included in the student
version. This initial case study of the semester introduces relevant
concepts and issues. Subsequent case studies following FOMC
announcements will describe the announcement and add concepts and
complexity throughout the semester.
Guide to Announcement
The first paragraph of the meeting announcement summarizes the
current monetary policy changes - this month it is the decision to leave the
target federal funds rate unchanged at 1 percent. The Federal Reserve
Board of Governors also sets the discount rate, through a technical process
of approving requests of the twelve Federal Reserve Banks. The discount
rate is not mentioned in the announcement and that implies that it was left
unchanged at the meeting.
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In the second paragraph, the Federal Reserve discusses the reasoning
behind their decision. The statement that “an accommodative stance of
monetary policy, coupled with robust underlying growth in productivity, is
providing important ongoing support to economic activity” shows that the
Federal Reserve views the recent policy of a decrease in the target federal
funds rate followed by a period of constant rates as proving effective. The
changes in this announcement are that the members of the Committee state
that “output is expanding briskly, and the labor market appears to be
improving modestly.” The statement that “output is expanding briskly”
compares to the previous “spending is firming”. The previous description
of the labor market was that it appears to be stabilizing. In addition, they
expect increases in prices to remain low. This is a relatively more positive
description of economic conditions than appeared in the announcement
following the last meeting in October.
In the third paragraph is the indication of likely future changes. The
Federal Reserve indicates that the risks of inflation and slowing spending
growth are balanced. This can be interpreted as the Committee members
believing that they will be unlikely to make additional changes between
now and the next meeting at the end of January. After the last meeting the
Committee expressed concern with the risk of deflation. Now, however,
the Federal Reserve believes that “the probability of an unwelcome fall in
inflation has diminished”. Much press attention was given to the
continuation of the use of the term “considerable period” to describe how
long the Committee believes that interest rates can be left as low as they
are. Apparently the Committee does believe that the target federal funds
rate will likely continue to be held at 1 percent or close to it for a
“considerable period”.
The fourth paragraph describes the votes of the FOMC members on
changing the target federal funds rate. In the past, there has been a lag
between the announcement and the publication of this information in the
minutes. This change, which was implemented last year, is one step in a
FOMC trend toward releasing more information immediately following
their meetings. All members of the FOMC voted to leave the target
federal funds rate unchanged.
Data Trends
During the last half of the 1990s, real GDP grew at rates more rapid
than those in the first half of the decade. That growth began to slow at the
end of 2000. Real GDP increased at annual rates of 4.5 percent and 3.7
percent in 1999 and 2000. During the first three quarters of 2001, real
GDP actually decreased. For 2001 as a whole, real GDP increased only
by .5 percent. The slowing growth over the last two quarters of 2000 and
all of 2001 was one indication of the need to use a monetary policy that
would boost spending in the economy. The FOMC responded, beginning
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in January of 2001, by cutting the target federal funds rate throughout the
rest of the 2001.
From January 3 to December 11 of 2001, the Federal Reserve Open
Market Committee (FOMC) lowered the target federal funds rate eleven
times from 6.50 percent to 1.75 percent, at that time, the lowest target
federal funds rate in forty years. During the fourth quarter of 2001, real
GDP rebounded, but only at an annual rate of 2.0 percent. Real GDP
increased only at a rate of 2.2 percent in 2002. At all of the 2002 meetings
prior to the November meeting, the FOMC decided to leave the federal
funds rate unchanged. In November, the target federal funds rate was
once again lowered to 1.25 percent. Then in June of 2003, following a
first quarter increase of only 2.0 percent, the target federal funds rate was
lowered once again, this time to 1 percent. (For more on changes in the
rate of growth of real GDP and the recession, see the most recent GDP
Case Study.)
Figure 1
Figure 1 shows the path of the target federal funds rate since 1990.
The gray areas indicate the recessionary periods in 1990-1991 and in
2001.
The FOMC used policies actively throughout much of the 1990s. The
FOMC had 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. Then
as inflationary pressures began to increase in 1994, the Federal Reserve
began to raise rates in February. In response to increased inflationary
pressures once again in 1999, the Federal Reserve raised rates six times
from June 1999 through May of 2000.
A Caution
Much of the attention in the press has been focused on the part of the
FOMC statement that expresses less concern with deflation. The press
attention centers on a discussion of when the FOMC may begin to increase
the target federal funds rate in response to rising concerns with future
inflation. For example, one analyst was quoted following the
announcement as follows – “Make no mistake, yesterday’s statement is
immensely significant. The groundwork for the first hike is being laid.”
Much of the recent press attention was also discussing whether or not
the FOMC would drop the description of their plans to hold interest rates
down “for a considerable period”. They obviously kept that statement in
the announcement. We should be cautious in attaching too much attention
to any one part of an announcement. It is no surprise that the FOMC will
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eventually increase the target federal funds rate. However, they have
stated that the existing level will continue “for a considerable period” and
the minutes of their October meeting indicate a possibility of a constant
target federal funds rate throughout much or all of the next year. One of
the conclusions was that weaknesses in the labor market might not solved
until the latter part of 2005 or even later.
Recessions
The National Bureau of Economic Research (NBER) announced
though its Business Cycle Dating Committee that it had determined that a
peak in business activity occurred in March of 2001. That signals the
official beginning to a recession. This year it announced that the recession
officially ended in November of 2001.
The NBER defines a recession as a "significant decline in activity
spread across the economy, lasting more than a few months, visible in
industrial production, employment, real income, and wholesale-retail
trade." The current data show a decline in employment, but not as large as
in the previous recession. Unemployment has also increased during the
period overall. Real income growth slowed but did not decline.
Manufacturing and trade sales and industrial production have both
declined and now appear to be turning around.
While the common media definition of a recession is two consecutive
quarters of decline in real GDP, this recession began before quarterly real
GDP was actually reported as having declined.
The previous recession began in July of 1990 and ended in March of
1991, a period of eight months. However, the beginning of the recession
was not announced until April of 1991 (after the recession had actually
ended). The end of the recession was announced in December of 1992,
almost 21 months later. One of the reasons the end of the recession was so
difficult to determine was the economy did not grow very rapidly even
after it came out a period of falling output and income.
For the full press release from the National Bureau of Economic
Research, see: http://cycles-www.nber.org/cycles/recessions.html
Deflation
Deflation is the opposite of inflation. We experience deflation if
prices across the economy, that is, if most prices or prices on average, are
falling. This announcement refers to a diminished probability of “an
unwelcome fall in inflation.” As recent inflation has been quite low, the
FOMC announcements since May have mentioned concerns that inflation
might turn into deflation.
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Why should we be concerned with falling prices? Lower prices sound
good. The concern is that if prices throughout the economy are falling and
if consumers and businesses expect prices to continue to fall, they may
reduce spending because they expect even lower prices in the near future.
That would put further downward pressure on spending, production, and
employment and perhaps lead to another recession.
In addition, businesses and individual debtors may face increased
pressures. As sales (and incomes) and therefore profits fall, monthly
payments on debt do not change. Instead they become an ever-increasing
percentage of income and make it more difficult to make timely payments.
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 January 27 and 28, 2004.) The seven Governors of the Federal
Reserve Board and five of the twelve Presidents of the Federal Reserve
Banks make up the committee. Governors are appointed by the U.S.
President and confirmed by the U.S. Senate. The Boards of each Federal
Reserve Bank select the presidents of the banks.
Figure 2
Tools of the Federal Reserve
For a description of tools of the Federal Reserve, see the October 28,
2003 FOMC Case Study.
Open Market Operations
The Federal Reserve buys and sells bonds 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
changes. That, in turn, decreases or increases interest rates. Open
market operations are the primary tool of the Federal Reserve. They
are often used and are quite powerful. This is what the Federal
Reserve actually does when it announces a new target 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, that interest rate is likely to increase.
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Banks earn profits by accepting deposits and lending some of those
deposits to someone else. They sometimes charge fees for establishing
and maintaining accounts and always charge borrowers an interest
rate. Banks are required by the Federal Reserve System to hold
reserves in the form of currency in their vaults or deposits with
Federal Reserve System.
When the Federal Reserve sells a bond, an individual or institution
buys the bond with a check on their account and gives the check 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 customer’s account. Thus, the money supply shrinks.
Discount Rate
The discount rate is the interest rate the Federal Reserve charges
banks if banks borrow reserves from the Federal Reserve itself. Banks
seldom borrow reserves from the Federal Reserve and tend to rely
more on borrowing reserves from other banks when they are needed.
The discount rate is often changed along with the target federal funds
rate, but the discount rate change does not have a very important
effect. In this announcement, the discount rate is not changed.
(Note: In January of 2003, the discount rate was changed to a
level one percent above the target federal funds rate. The discount
rate had normally been about one-half of a percent less than the target
federal funds rate. Technical aspects of borrowing from the Fed were
also changed at the same time. The basic functions of monetary policy
were not changed.)
Reserve Requirements
Banks are required to hold a portion (either 10 or 3 percent of
most deposits, depending upon the size of the bank) of some of their
deposits in reserve. Reserves consist of the amount of currency that a
bank holds in its vaults and its deposits at Federal Reserve banks. If
banks have more reserves than they are required to have, they can
increase their lending. If they have insufficient reserves, they have to
curtail their lending or borrow reserves from the Federal Reserve or
from another bank that may have extra, or what are called excess,
reserves. The requirement is seldom changed, but it is potentially very
powerful.
How does Monetary Policy Work?
Monetary policy works by affecting the amount of money that is
circulating in the economy. The Federal Reserve can change the amount
of money that banks are holding in reserves by buying or selling existing
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U.S. Treasury bonds. When the Federal Reserve buys a bond, the seller
deposits the Federal Reserves' check in her bank account. As a bank’s
reserves increase, it has an increased ability to make more 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, total
spending increases. Consumer spending that partially depends upon levels
of interest rates (automobile and appliances, for example) is also affected.
Output will tend to follow and employment may also increase. Thus
unemployment will fall. Prices may also increase.
When the Federal Reserve employs an expansionary monetary policy,
it buys bonds in order to expand the money supply and simultaneously
lower interest rates. Although gross domestic product and investment
increase, this may also stimulate inflation. If growth in spending exceeds
growth in capacity, inflationary pressures tend to emerge. If growth in
spending is less than the growth in capacity, then the economy will not be
producing as much as it could. As a result, unemployment may rise.
When the Federal Reserve adopts a restrictive monetary policy it sells
bonds in order to reduce the money supply and this results in higher
interest rates. A restrictive monetary policy will decrease inflationary
pressures, but it may also decrease investment and real gross domestic
product. See the Inflation Case Study for a more detailed discussion of
inflation.
Comparison of Monetary and Fiscal Policy
The FOMC has been reacting to the slowing economy over the past
year. While the monetary policy has not been sufficient to prevent a
recession, it surely has made the recession milder than it would have been
otherwise and has likely contributed to the recession ending sooner.
Fiscal policy, the taxing and spending policies of the federal
government, has the potential to influence economic conditions.
Throughout this year, there have been debates in Congress about what to
do with spending and taxes in order to stimulate spending. These debates
continue and little has been accomplished this year. The challenges of
quick responses point to one of the key differences between fiscal and
monetary policy. Fiscal policy is much more difficult to implement but
has a faster effect spending. Monetary policy decisions are much easier to
institute and more responsive to economic conditions, but may take longer
to have a full effect.
Creation of the Federal Open Market Committee
See the previous FOMC Case Study for more on the background of the
structure of the FOMC.
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A Research Project
Look at the last four announcements - all of the announcements since
the June 25th lowering of the target federal funds rate. Identify the
differences in the announcements. Compare the changes in the
announcements to what was occurring in labor markets at the same time.
(The August, September, and October, 2003 press releases are available at:
http://www.federalreserve.gov/BoardDocs/Press/monetary/2003/20030812/;
http://www.federalreserve.gov/BoardDocs/Press/monetary/2003/2003916/;
and
http://www.federalreserve.gov/BoardDocs/Press/monetary/2003/20031028/.
)
The only differences in the August, September, and October announcements
are found in the second sentence of the second paragraph. In August, the
announcement states that “…labor market indicators are mixed.” In
September, the announcement states that “…the labor market has been
weakening.” In October, the description is that “…the labor market
appears to be stabilizing.” (The September and October announcements
also change the August statement that evidence “shows” that spending is
firming to the evidence “confirms” that spending is firming.)
In December, the addition is that the evidence confirms that “…output is
expanding briskly, and the labor market appears to be improving modestly.”
(There is also an addition that increase in prices are “expected to remain
low”.) Finally, the December announcement in the third paragraph does
make a change that states the FOMC believes that the probabilities of a fall
and of a rise in prices are almost equal, where earlier they were more
concerned with the possibility of a fall.
At the August meeting, unemployment had fallen slightly in the previous
month and employment was continuing to fall. At the September and
October meetings, unemployment continued to decrease, but very gradually.
Employment was beginning to increase. At the December meeting,
unemployment was still decreasing slowly, but there were two more months
of increases in employment, albeit less than the increases necessary to
reduce unemployment significantly.
Interactive Button Questions
1. What are the Federal Reserve’s monetary policy tools?
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Open market operations (changing the target federal funds rate), the
discount rate, and the required reserves ratio.
2. If the Federal Open Market Committee announces that it is raising the
target federal funds rate, the FOMC will ___________ bonds.
Buy
Sell
Sell bonds to reduce the supply of reserves banks have, thereby raising
the federal funds rate, the rates banks charge one another for reserves.
3. If the Federal Open Market Committee is concerned that
unemployment is increasing while inflation is decreasing, the FOMC
will likely ______________ bonds.
Buy
Sell
Buy bonds in order to increase the money supply and decrease the
target federal funds rate.
4. If the Federal Open Market Committee is concerned with increasing
inflationary pressures at the same time unemployment is likely to fall,
it will likely ______________ bonds.
Buy
Sell
Sell bonds in order to reduce the money supply and increase the target
federal funds rate.
5. If the Federal Reserve Board and the Bank presidents are concerned
with increasing inflationary pressures at the same time unemployment
is likely to fall, they will likely ______________ the discount rate.
Increase
Decrease
Increase the discount rate as a signal that the Federal Reserve intends
to use a tight monetary policy.
6. If the Federal Reserve Board members are forecasts decreasing
inflationary pressures at the same time unemployment is likely to rise
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and they are considering changing the required reserve ratio, they will
likely ______________ the required reserve ratio.
Increase
Decrease
Decrease the required reserve ratio to increase the total amount of
loans (and therefore the money supply) that banks can make.
QUESTIONS
1. What are the Federal Reserve current observations and concerns?
2. What tools can the Federal Reserve use?
3. If the Federal Reserve becomes concerned about too much growth in
spending in the economy, what is it likely to do with its open market
operations and the federal funds rate?
4. If the Federal Reserve is concerned about lack of economic expansion
and decided to use changes in reserve requirement and the discount
rate, what would it do?
5. How does an expansion of bank reserves affect spending in the
economy?
Answers to Questions
1. The Federal Reserve is optimistic about future conditions. Output is
“expanding briskly”. There is less concern than there has been that
deflation is a potential problem.
2. The Federal Reserve can buy or sell bonds, which in turn lower or
increase the federal funds rate. The Federal Reserve can also change
reserve requirements and the discount rate.
3. The Federal Reserve would sell bonds to reduce the money supply and
reserves and thus increase the target federal funds rate.
4. The Federal Reserve would lower reserve requirements and decrease
the discount rate.
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5. If banks have more reserves, they can make as more loans. As all
banks are eager to increase their loans, the increased supply is likely
to decrease the interest rates they are able to charge. The increase in
loans and the resulting lower interest rates encourage business to
borrow and invest and make it easier for consumers to increase their
spending.
Key Concepts
Discount rate
Federal funds rate
Federal Open Market Committee
Federal Reserve System
Fiscal policy
Interest rates
Monetary policy
Open market operations
Reserve requirements
Relevant National Economic Standards
11. Money makes it easier to trade, borrow, save, invest, and
compare the value of goods and services. Students will be able to
use this knowledge to explain how their lives would be more
difficult in a world with no money, or in a world where money
sharply lost its value.
12. Interest rates, adjusted for inflation, rise and fall to balance
the amount saved with the amount borrowed, which affects the
allocation of scarce resources between present and future uses.
Students will be able to use this knowledge to explain situations, in
which they pay or receive interest, and explain how they would
react to changes in interest rates if they were making or receiving
interest payments.
15. Investment in factories, machinery, new technology and in the
health, education, and training of people can raise future
standards of living. Students will be able to use this knowledge to
predict the consequences of investment decisions made by
individuals, businesses, and governments.
16. There is an economic role for government in a market
economy whenever the benefits of a government policy outweigh
its costs. Governments often provide for national defense, address
environmental concerns, define and protect property rights, and
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attempt to make markets more competitive. Most government
policies also redistribute income. Students will be able to use this
knowledge to identify and evaluate the benefits and costs of
alternative public policies, and assess who enjoys the benefits and
who bears the costs.
18. A nation's overall levels of income, employment, and prices
are determined by the interaction of spending and production
decisions made by all households, firms, government agencies, and
others in the economy. Students will be able to use this knowledge
to interpret media reports about current economic conditions and
explain how these conditions can influence decisions made by
consumers, producers, and government policy makers.
19. Unemployment imposes costs on individuals and nations.
Unexpected inflation imposes costs on many people and benefits
some others because it arbitrarily redistributes purchasing power.
Inflation can reduce the rate of growth of national living standards
because individuals and organizations use resources to protect
themselves against the uncertainty of future prices. Students will be
able to use this knowledge to make informed decisions by
anticipating the consequences of inflation and unemployment.
20. Federal government budgetary policy and the Federal Reserve
System's monetary policy influence the overall levels of
employment, output, and prices. Students will be able to use this
knowledge to anticipate the impact of federal government and
Federal Reserve System macroeconomic policy decisions on
themselves and others.
Sources Of Additional Activities
Advanced Placement Economics: Macroeconomics. (National
Council on Economic Education)
UNIT FOUR: Money, Monetary Policy, and Economic
Stability
UNIT FIVE: Monetary and Fiscal Combinations:
Economic Policy in the Real World
Entrepreneurship in the U.S. Economy--Teacher Resource Manual
LESSON 10: The Nature of Consumer Demand
LESSON 11: What Causes Change in Consumer Demand?
LESSON 19: Financing the Entrepreneurial Enterprise
LESSON 32: Government Policies, the Economy, and the
Entrepreneur
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On Reserve: A Resource for Economic Educators from the Federal
Reserve Bank of Chicago. Number 28, April 1994: Basics
to Bank on
Economics USA: A Resource Guide for Teachers
LESSON 11: The Federal Reserve: Does Money Matter?
LESSON 12: Monetary Policy: How Well Does It Work?
LESSON 13: Stabilization Policy: Are We Still in Control?
Handbook of Economic Lesson Plans for High School Teachers
LESSON EIGHTEEN: The Federal Reserve System
LESSON NINETEEN: Making Monetary Policy: The Tools
of the Federal Reserve System
Focus: High School Economics
20. Money, Interest, and Monetary Policy
All are available in Virtual Economics, An Interactive Center for
Economic Education (National Council on Economic Education) or
directly through the National Council on Economic Education.
For more background on the Federal Reserve and resources to use in
the classroom, go to www.federalreserve.gov.
Authors: Stephen Buckles
Erin Kiehna
Vanderbilt University
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