Download Federal Open Market Committee (FOMC)

A Case Study
The Federal Reserve
Monetary Policy
Date of Announcement
March 28, 2006
Date of next Federal Open Market Committee Announcement
May 10, 2006
Reasons for a Case Study 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 to either boost spending and
employment in the U.S. economy or to slow growth in spending. The
announcements reflect serious concerns with the state and direction of the
economy and the resulting policy actions.
This case study is intended to guide students and teachers through an analysis
of the actions the Federal Reserve is currently taking in an effort to reduce the
amount of stimulus that it had been providing 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 second 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. This
case adds an explanation of the discount rate and a comparison with the previous
announcement. (Slides showing each paragraph of the excerpts of the
announcement are included in the accompanying PowerPoint slides.)
Announcement
The following is an excerpt from the March 28 announcement.
The Federal Open Market Committee decided today to raise its target
for the federal funds rate by 25 basis points to 4-3/4 percent.
The slowing of the growth of real GDP in the fourth quarter of 2005
seems largely to have reflected temporary or special factors.
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Economic growth has rebounded strongly in the current quarter but
appears likely to moderate to a more sustainable pace. As yet, the runup in the prices of energy and other commodities appears to have had
only a modest effect on core inflation, ongoing productivity gains have
helped to hold the growth of unit labor costs in check, and inflation
expectations remain contained. Still, possible increases in resource
utilization, in combination with the elevated prices of energy and
other commodities, have the potential to add to inflation pressures.
The Committee judges that some further policy firming may be
needed to keep the risks to the attainment of both sustainable
economic growth and price stability roughly in balance. In any event,
the Committee will respond to changes in economic prospects as
needed to foster these objectives.
In a related action, the Board of Governors approved a 25-basis-point
increase in the discount rate to 5-3/4 percent. In taking this action, the
Board approved the requests submitted by the Boards of Directors of
the Federal Reserve Banks of Boston, New York, Philadelphia,
Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis,
Dallas, and San Francisco.
The complete press release is available at:
http://www.federalreserve.gov/boarddocs/press/monetary/2006/20060328/
Interactive exercise:
Does this announcement signal a change in monetary policy or a continuation
of recent policy?
A change
A continuation
Responses:
To “A change”: It is a change in the target federal funds rate, but is a
continuation of increases in the target federal funds rate that has been
occurring since the June 2004 meeting.
To “A continuation”: Yes, that is correct. This is a continuation of
increases in the target federal funds rate that has been occurring since
the June 2004 meeting.
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Does this announcement signal a change in efforts to encourage growth in
spending in the economy or is it more likely an attempt to reduce such
encouragement?
To encourage
growth
To reduce
growth
Responses:
To “To encourage growth”: No, that is incorrect. It is believed that
current interest rate levels are encouraging growth in spending and
there is no longer a need to do so.
To “To reduce growth”: Yes, that is correct. It is believed that
current interest rate levels are encouraging growth in spending and
there is no longer a need to do so.
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 May
10, 2006.) The seven Governors of the Federal Reserve Board and five of the
twelve Presidents of the Federal Reserve Banks make up the committee. The staff
of the Federal Reserve implements the recommended policies.
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 seven Board members constitute a majority of the 12-member FOMC.
The other five members of the FOMC are Reserve Bank presidents, one of whom
is always the president of the Federal Reserve Bank of New York. The other Bank
presidents serve one-year terms on a rotating basis. Traditionally, the Chairman of
the Board of Governors serves as the Chairman of the FOMC.
Guide to the Announcement
The Federal Open Market Committee has increased the target for its federal
funds rate at each of its meetings since June 2004. This is the fifteenth meeting in
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a row at which the target for the federal funds rate has been increased by .25
percent.
The first paragraph of the announcement summarizes the current monetary
policy changes - this month it is the decision to increase the target federal funds
rate - increasing the target from 4.50 percent to 4.75 percent.
The language used to describe the increase assumes an understanding the
definition of a basis point. There are 100 basis points in one percent of interest.
Thus, an increase of 25 basis points is equal to one-quarter of one percent. The
target for one interest rate – the federal funds rate – is being increased from 4.50
percent to 4.75 percent.
The first paragraph is identical to the first paragraph in the January 31
announcement, except that then the rate was increased from 4.25 to 4.50 percent.
See the copy of the announcement below for specific indications of changes.
A brief summary of the reasoning behind the decision is presented in the
second and third paragraphs.
In the second paragraph, the slowing of growth in the final quarter of 2005
and the faster growth since are recognized. The committee believes the economy
continues to expand, but will do so at a pace that can continue.
The increases in energy prices do not yet seem to have a serious effect on
inflationary expectations. If increasing inflationary expectations were evidenced
it is likely that the committee would have increased the target federal funds rate at
a more rapid rate. The increases in productivity appear to be holding price
pressures down.
However, the economy may be approaching a higher utilization of its
capacity, which may increase inflationary pressures in the future.
The third paragraph is identical to that paragraph in the January
announcement. The committee indicates that the risks are balanced between
inflation (“price stability”) and sustainable economic growth. This means that
the chances of increased inflation and chances of a slowdown in the economic
growth are about equal. However, in order to maintain that balance, the
committee believes that it will need to continue its increases in the target federal
funds rate in the future. The phrase “further policy firming” means that the
FOMC will continue its increase in the target federal funds rate in order to remove
the stimulate effects of the low rates in 2002, 2003, and 2004.
The final sentence in the third paragraph is added simply to reassure analysts
that if expectations of inflation change or rates of increase in spending slow, the
FOMC will change its policy quickly and change the target for the federal funds
rate in an appropriate manner. If increased inflationary pressure appear, the
FOMC is likely to increase the target federal funds rate more rapidly. If growth in
spending in the economy were to slow, the FOMC would be likely to decrease the
target.
The Federal Reserve Board of Governors actually sets another interest rate
known as the discount rate. This is the focus of the fifth paragraph. The process
is one of approving requests for a change received from the twelve Federal
Reserve Banks. In this announcement, the discount rate is increased by ¼ of one
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percent to a level of 5.75 percent. More discussion of the discount rate follows
below.
There is also a fifth paragraph in a typical announcement. That paragraph
will be discussed in the next case study.
Identical to
the January
statement
except that
the target for
the federal
funds rate
was 4.5
percent.
Comparison of the Current Announcement with the Previous Announcement
The Federal Open Market Committee decided today to raise its target
for the federal funds rate by 25 basis points to 4-3/4 percent.
In January, the
FOMC
announcement read,
“although recent
economic data have
been uneven, the
expansion in
economic activity
appears solid.”
The slowing of the growth of real GDP in the fourth quarter of 2005
seems largely to have reflected temporary or special factors. Economic
growth has rebounded strongly in the current quarter but appears
likely to moderate to a more sustainable pace.
As yet, the run-up in the prices of energy and other commodities
appears to have had only a modest effect on core inflation, ongoing
productivity gains have helped to hold the growth of unit labor costs in
check, and inflation expectations remain contained.
In January,
this
paragraph
was identical.
Still, possible increases in resource utilization, in combination with
the elevated prices of energy and other commodities, have the
potential to add to inflation pressures.
The Committee judges that some further policy firming may be
needed to keep the risks to the attainment of both sustainable
economic growth and price stability roughly in balance. In any
event, the Committee will respond to changes in economic
prospects as needed to foster these objectives.
Data Trends
In January, the
statement read,
“Core inflation has
stayed relatively low
in recent months and
longer-term inflation
expectations remain
contained. “
In January, the paragraph was
basically identical.
“Nevertheless, possible
increases in resource
utilization as well as elevated
energy prices have the
potential to add to inflation
The FOMC used policies actively throughout much of the 1990s. The
pressures.”
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. See the figure showing
changes in the target. (The periods of the 1990-1991 recession and the 2001
recession are shown in gray on the graph.)
Federal Funds Rate Graph
Then as inflationary pressures began to increase in 1994, the Federal Reserve
began to raise rates. In response to increased inflationary pressures once again in
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1999, the Federal Reserve raised rates six times from June 1999 through May of
2000. Those changes are obvious in the graph.
Growth began to slow at the end of 2000. The slowing growth was one
indication of the need for a change in monetary policy that would boost spending
in the economy. The FOMC responded by cutting the target federal funds rate
throughout the year.
Then as the economy began to recover from the recession and the FOMC
turned to concerns that the economy did not need as much stimulation, a series of
“measured” increases in the target were undertaken and are continuing with the
current increase. Certainly the FOMC will increase the target federal funds rate
once more at its next meeting (unless conditions change, as referenced at the end
of the third paragraph) and perhaps will increase the target twice or three times
more.
Tools of the Federal Reserve
The Federal Reserve buys and sells bonds and by doing so, increases or
decreases banks' reserves and banks’ 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”, that is buying or selling, in the “open market” for U.S. Treasury
securities.
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. The opposite occurs when the Federal
Reserve buys a bond. The Federal Reserve gives a check to the seller of the bond.
The seller deposits the check in their account. Their bank adds to the amount to
the deposits and thus the money supply increases. The bank also presents the
check back to the Federal Reserve, which in turn adds the amount to the bank’s
reserves. Because the bank has to keep only a portion of those reserves, the bank
makes loans with the remainder. Thus the money supply expands even further.
As banks attempt to make more loans, interest rates fall.
Open market operations are the primary tool of the Federal Reserve. It is a
tool that is often used and is quite powerful. This is what the Federal Reserve
actually does when it announces a new target for its 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 because the Federal Reserve has
sold bonds, that interest rate is likely to increase. If the supply of reserves is
increased because the Federal Reserve has purchased bonds, that interest rate is
likely to decrease.
Banks earn profits by accepting deposits and lending part 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
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Federal Reserve System to hold reserves in the form of currency in their vaults or
deposits with Federal Reserve System.
The Discount Rate
The discount rate is the interest rate the Federal Reserve charges banks if
banks 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.
In reality, banks seldom borrow reserves from the Federal Reserve and tend to
rely more on borrowing reserves from other banks when they are needed. They
will still pay an interest rate (the federal funds rate), but that is a rate determined
in the market for reserves and influenced by the open market operations of the
Federal Reserve.
The discount rate is most often changed along with the target for the federal
funds rate, but the discount rate change does not have a very important effect as
so few banks actually use that means of borrowing reserves. In this
announcement, the discount rate is increased along with the federal funds rate.
Figure 2 shows the discount rate along with the federal funds rate. Notice that
the discount rate typically changes along with the target for the federal funds rate.
Prior to 2003, the discount rate was below the target federal funds rate. Since then
the discount rate has been one percent above the target federal funds rate. That is
an additional reason that there is little current borrowing of reserves directly from
the Federal Reserve.
Federal Funds Rate and Discount Rate Graph
The Federal Reserve has one other tool that could be used to influence the
expansion and contraction in the money supply and it will be introduced in the
next FOMC case study.
Note about Chairman of the Federal Reserve
This was the first meeting of the FOMC chaired by the new Chairman of the
Board of Governors of the Federal Reserve Bank, Benjamin Bernanke. Bernanke
was nominated by the President and approved by the Senate as the new chair
following more than 18 years of service in that role by Alan Greenspan.
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
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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.
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, machines, and tools, total
spending increases. Consumer spending that partially depends upon levels of
interest rates (automobile and appliances, for example) is also affected. Output
and employment. In this case, unemployment will fall. There may also be some
upward pressure on prices.
When the Federal Reserve adopts a restrictive monetary policy, it sells bonds
in order to reduce the money supply. This results in higher interest rates and less
spending. A restrictive monetary policy will decrease inflationary pressures, but
it may also decrease investment spending and real gross domestic product. See
the Inflation Case Study for a more detailed discussion of inflation.
Interactive questions –
1. If the FOMC is concerned about a potential of rising unemployment, it
would likely:
Expand the
money supply
Contract the
money supply
Pop up:
If first box, then –
If second box, then –
Yes, the correct answer
is to increase the money
supply
No, the correct answer is
to increase the money
supply
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2. If the FOMC is concerned about a forecast of increasing inflation, it would
likely:
Purchase bonds
Sell bonds
Pop up:
If first box, then –
No, the correct answer is
to sell bonds in order to
decrease the money
supply
If second box, then –
Yes, the correct answer
is to sell bonds in order
to decrease the money
supply
3. If the FOMC is concerned about spending that is growing too slowly, it
would likely:
Raise its target
for the federal
funds rate
Lower its target
for the federal
funds rate
Pop up:
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If first box, then –
No, the correct answer is
to decrease the target
federal funds rate by
buying bonds in order to
increase the money
supply
If second box, then –
Yes, the correct answer
is to decrease the target
federal funds rate by
buying bonds in order to
increase the money
supply
4. If the Federal Reserve wishes to slow the economy in order to decrease
spending, which of the following actions is appropriate?
Raise the
discount
rate
Decrease the
discount rate
If the answer chosen is the first box, then –
Yes, that is correct. That will
discourage bank borrowing and thus
lead to slowing growth in the money
supply
If the answer chosen is the second box, then –
No, that is not correct.
A decrease will encourage bank
borrowing and thus lead to rising
growth in the money supply
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Comparison of Monetary and Fiscal Policy
The FOMC reacts to a slowing economy by expanding the money supply,
lowering interest rates, and creating increased spending. The reaction to
increasing inflationary pressures is to decrease the money supply, raise interest
rates, and thereby slowing growth in spending.
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. If the economy is entering a
recession, 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.
In those processes, there will be debates in Congress about what to do with
spending and taxes in order to stimulate or slow overall spending in the economy.
These debates normally take a substantial amount of time. This lag points to one
of the key differences between fiscal and monetary policy. Fiscal policy is much
more difficult to implement but once the decision is made, it takes effect quickly.
Monetary policy decisions are much easier to institute and more responsive to
economic conditions, but actually take longer to change spending once the
decision is made.
QUESTIONS
1. What are the Federal Reserve current observations and concerns?
2. What tool will the Federal Reserve use to accomplish its goals?
3. If the Federal Reserve were to become concerned about a slowing of the
economic expansion, what is it likely to do with its open market operations
and the federal funds rate?
4. How do changes in monetary policy affect your family’s spending and
business spending in the economy?
Answers to Questions
1. The Federal Reserve believes that the economy is growing without significant
inflationary pressure. The goal is to remove the stimulative pressure created
by low interest rates. It is implying that it will continue the gradual increases
in the target federal funds rate, but is ready to change the direction of
monetary policy if new conditions warrant.
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2. The Federal Reserve can buy or sell U.S. Treasury bonds, which in turn will
lower or increase the federal funds rate. To reduce the stimulative effects of
recent policy, the FOMC is increasing the target for the federal funds rate.
That means that the Federal Reserve is selling bonds. (Or it means that the
Federal Reserve is slowing the growth of the money supply by purchasing
fewer bonds than it otherwise would.)
3. The Federal Reserve would purchase more bonds to expand the money supply
and bank reserves and that would lower the federal funds rate. The goal
would be to increase overall spending in the economy.
4. If the Federal Reserve is selling bonds, banks will have lower reserves due to
decreased deposits. With the decreased reserves, banks will have to decrease
the number and size of loans. The decrease in loans and the resulting higher
interest rates discourage business (and consumer) borrowing and spending.
The decreased spending in the economy should result in decreased business
production and employment.
Key Concepts
Federal funds rate
Federal Open Market Committee
Federal Reserve System
Interest rates
Monetary policy
Open market operations
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
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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 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
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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
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.
Author: Stephen Buckles
Vanderbilt University
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