The Federal Open Market Committee (FOMC: the body of the Fed that determines mon

Question

The Federal Open Market Committee (FOMC: the body of the Fed that determines monetary policy) just concluded their latest meeting (April 26-27). For this assignment, you will need to read two articles: first, find a factual article from a major news source that describes what was decided at the meeting and why; second, find an opinion piece (which can be from any news source) that either agrees or disagrees with the Fed’s handling of the economy. Your opinion article should be very recent.

• Briefly recap what the Fed decided to do with interest rate policy and why they made this decision.

• Regarding the opinion piece, what are the author’s main points? What is your take on the opinion piece and on the Fed’s policies?

Explanation / Answer

We begin with the Fed funds Rate. The Fed funds rate is the interest rate the Fed targets with open market operations. This is a very short-term interest rate that depends on the level of excess reserves present in the vaults of banks. By engaging in an expansionary policy, the Fed is using open market operations to buy bonds from the asset portfolios of some banks. As these banks sell bonds to the Fed, their cash reserves increase, creating excess reserves, and expanding the monetary base.

Since banks do not earn any return on excess reserves, they immediately look to loan out the excess reserves. If a bank with excess reserves cannot immediately find a long-term borrower, it can still earn interest. One way for a bank to make a loan is through the Fed Funds market where other banks borrow money for a short-term duration (overnight or a few days).

When the Fed buys bonds from individual banks, it creates excess reserves for those banks. Other banks may need to raise money on a short-term basis if they have fallen below their reserve requirement and/or need to raise money to make a loan to a corporate customer. Or the borrowing banks may desire to engage in other financial transactions and do not want to wait for deposit inflows to raise the necessary money.

We can see the connection between Fed open market operations and short-term interest rates. If the Fed is undertaking an expansionary policy (buying bonds), some banks will find themselves with an increased supply of excess reserves when they sell part of their government bond portfolio to the Fed. As the supply of excess reserves rises, banks will lower the interest rate they charge other banks to borrow short-term in the Fed funds market. As a result, the Fed funds interest rate decreases.

Having succeeded in lowering the Fed funds rate, the Fed assumes that longer-term interest rates will follow. This is a very important point regarding Fed monetary policy. While the Fed can directly control the Fed funds interest rate, it only has indirect control over longer-term interest rates.

The key to attaining the Fed's goal of changing the growth rate of GDP lies in long-term interest rates. Changes in long-term interest rates create a response in business investment activity and consumer borrowing. Lower interest rates reduce the cost and increase the profitability of borrowing through the present value calculation. The same holds for the consumer, who will see a reduction in monthly payments for new loans taken out or for those loans adjusted to falling market interest rates.

The critical question is how effective is the Fed in translating policy decisions that change the Fed funds rate (short-term) into actual changes in longer-term interest rates? Only if longer-term interest rates adjust to changes in short-term interest rates will business investment and consumer spending react to Fed policy. And it is through changes in investment and consumption that the Fed will influence the growth rate of GDP.

How effective the Fed will be in determining the direction of long-term interest rates depends on changes in the spread or gap between short-term and long-term rates. The historical gap between the 3-month Treasury bill rate and the long-term government Treasury bond is about 2%. The longer the maturity of the debt, the higher is the associated interest rate. If the Fed lowers short-term interest rates by 0.5% (1/2 a basis point), the Fed's goal is to maintain a constant spread. In this case long-term rates will also fall by 0.5% and investment and consumption activity will increase.

In the early 1990s, the spread between short-term and long-term interest rates reached a new high. This was a consequence of expected inflation in the future caused by the massive federal budget deficits of the 1980s and early 1990s. Long-term interest rates had an additional inflationary premium built in because of expected future inflation relating to the fiscal budget deficit. For our purposes here, we will assume a constant spread between long and short interest rates. In other words, when the Fed changes the Fed funds rate, all other interest rates will move in the same direction and by a similar magnitude. In this way we can base our discussion on a single rate of interest, r.

A restrictive monetary policy is a decision by the Fed to raise interest rates in order to slow the growth rate of GDP. In 1994, the Fed raised the Fed funds rate seven times in order to achieve a soft landing for the U.S. economy.

When open market operations are used to implement a restrictive monetary policy, the Fed sells bonds to banks. By purchasing bonds from the Fed, banks have less money to loan out and the monetary base shrinks. The result is a reduction in the money supply by a factor of the money multiplier. The reduction in the money supply and bank reserves raises the Fed funds rate using the opposite of the process described above. As long-term interest rates increase along with the Fed funds rate, business investment and consumer borrowing both decrease, resulting in slower GDP growth.

Changes in the Reserve Requirement and the Discount Rate

The Fed uses open market operations to carry out the great majority of its policy decisions. On occasion, the Fed will change the percentage of deposits that banks must keep on reserve with the Fed (the reserve requirement). If the Fed lowers the reserve requirement as part of an expansionary monetary policy, banks will have additional money that can be lent out to businesses and consumers. The value of the money multiplier will also increase. The net effect is to increase the money supply, lower interest rates, and increase the GDP growth rate.

A restrictive monetary policy by the Fed involves increasing the reserve requirement to reduce bank lending and decrease the value of the money multiplier. The money supply contracts, raising interest rates and reducing GDP growth as investment and consumption decline due to the higher interest rates.

Due to the dramatic effects on the money multiplier, the Fed seldom changes the reserve requirement. The Fed will only use this policy in circumstances of severe recession or inflation.

The discount rate is the interest rate that the Fed charges banks to borrow directly from the Fed. The discount rate is usually changed after the fact of a policy decision involving open market operations. If the Fed is using open market operations to carry out an expansionary monetary policy, it may follow up on changes in the Fed funds rate with a change in the discount rate. In this way, changes in the discount rate are used to confirm (to the public) the direction of Fed policy.

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