A CASE STUDY
The Federal Reserve System and Monetary Policy
The Federal Open Market Committee
Date of Announcement
January 27 and 28, 2004
Dates of Future Federal Open Market Committee Meetings
March 16, 2004
The Federal Reserve
leaves its target
federal funds rate
unchanged.
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. Although new hiring
remains subdued, other indicators suggest an improvement in the labor
market. 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. With inflation quite low and resource use slack, the
Committee believes that it can be patient in removing its policy
accommodation.
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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; Roger W. Ferguson, Jr.; Edward M. Gramlich; Thomas
M. Hoenig; Donald L. Kohn; Cathy E. Minehan; Mark W. Olson;
Sandra Pianalto; and William Poole.”
This press release is available at:
http://www.federalreserve.gov/BoardDocs/Press/
monetary/2004/20040128/
Reasons for a Case Study on the Federal Open Market Committee
The target federal funds rate is at a record low as the Federal Reserve
monetary policy committee (the Federal Open Market Committee or
FOMC) has concerned itself with encouraging economic growth following
the recession in 2001.
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 is only discussed when
there is a change.
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, quite low, rates as proving
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effective. The committee continues to believe that output is expanding at
a healthy pace. However, one change in the announcement is the
replacing of “the labor market appears to be improving modestly” with
“Although new hiring remains subdued, other indicators suggest an
improvement in the labor market.” The reference is most likely due to the
fall in the unemployment rate combined with a relatively small increase in
employment. (Alternative measures of employment do show that
employment, particularly among self-employed and new companies, may
be improving more rapidly than the announced increases in employment.)
In addition, the announcement states that the committee expects increases
in prices to remain low.
For an indication of the changes in the announcement from the
December announcement, click on the following link. [Comparisons of
January and December announcements.]
An indication of likely future changes is in the third paragraph. The
Federal Reserve indicates that the risks of inflation and slowing spending
growth are balanced. That is the meaning of “roughly balanced”. It
means that the committee believes that spending is neither growing too
fast or too slow when compared to our abilities to produce and is unlikely
to do so in the near future. This also can be interpreted as the committee
members believing that they will be unlikely to make additional changes
between now and the next meeting in March.
Two meeting ago, 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”. In recent
policy announcements the Federal Reserve has stated that it intends to
maintain current policy for a “considerable period”. With this
announcement, the committee has changed that statement to “…the
committee believes that it can be patient in removing its policy
accommodation.” The change received much attention in the press and
many described it as an indication of a major change in policy.
We should be cautious with the degree of coverage of this particular
change. It should not surprise any thoughtful observer that eventually the
economy will fully recover from the 2001 recession and that the Federal
Reserve will begin to raise the target federal funds rate.
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 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. [There is
an actual change in some of the voting members as the actual voting
rotates among the Federal Reserve bank presidents.]
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Data Trends
The FOMC used monetary 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.
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 third quarter of 2000 and 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 and actual
decline in real GDP over the last two quarters of 2000 and all of 2001
were indications of the need to use a monetary policy that would boost
spending in the economy. The FOMC responded, beginning 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 in real GDP 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.) The target federal funds rate has not been
changed since.
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.
A Caution
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Much of the attention in the press has been focused on the part of the
FOMC statement that is changed from the previous announcement. 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 has discussed whether or not the
FOMC would drop the description of their plans to hold interest rates
steady at a relatively low level “for a considerable period”. They
obviously did not keep that statement in the announcement. We should be
cautious in attaching too much attention to any one part or change in an
announcement. It is no surprise that the FOMC will eventually increase
the target federal funds rate.
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
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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 March 16, 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
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
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.
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Tools of the Federal Reserve
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.
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
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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.
Exercises. (with interactive button questions)
1. A sample headline following the FOMC announcement:
“Fear of Rising Interest Rates Sends Markets Into Decline”
(“Markets” refers to stock markets.)
Why would stock price declines be connected to a “fear of rising
interest rates”?
Answer - Suppose financial investors have two possibilities –
purchasing equities or opening bank accounts and earning
interest. The opportunity cost of purchasing a stock is the amount
that could be earned from interest. Thus if interest rates rise, the
true cost of purchasing stocks increases and demand for stocks
falls. Thus, stock prices will fall.
2. If the economy is growing slowly, what would the FOMC be likely to
do with the target federal funds rate?
Raise
Lower
Not change
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Lower the target federal funds rate in order to encourage increased
spending.
3. If the economy is beginning to grow at a faster rate, what would the
FOMC be likely to do with the target federal funds rate?
Raise
Lower
Not change
Raise the target federal funds rate in order to discourage increased
spending.
4. If interest rates increase, what would likely happen to spending in the
economy?
Increase
Decrease
Not change
Decrease as borrowing becomes more expensive and that cause some types
of spending to decrease.
5. What are the Federal Reserve’s monetary policy tools?
Open market operations (changing the target federal funds rate), the
discount rate, and the required reserves ratio.
6. 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.
7. If the Federal Open Market Committee is concerned that
unemployment is increasing while inflation is decreasing, the FOMC
will likely ______________ bonds.
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Buy
Sell
Buy bonds in order to increase the money supply and decrease the
target federal funds rate.
8. 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.
9. More advanced – If interest rates are increased to slow down a growing
economy where profits and sales are rising, what is likely to happen to
average stock prices?
Increase
Decrease
Not change
Increase, decrease, or not change. Higher profits and sales should
cause price of shares of stocks to increase. Higher interest rates
should cause lower prices of stocks. Depending upon which effect has
the greatest effect on buyers and sellers of stocks, prices can move in
either direction due to the offsetting forces.
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
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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
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
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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
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
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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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