Financial Update (January-March 2001)
Financial Update (January-March 2001)
Did You Know?
DID YOU KNOW?
Federal Open Market Committee Plays Major Role in Monetary Policy
very six weeks or so, usually on a Tuesday, news anchors announce that the Federal Open Market Committee (FOMC) has met that day and has either raised or lowered interest rates or left rates the same. Such glib sound bites fail to capture the complex nature of the FOMC’s primary task — setting U.S. monetary policy.
Some reporters have even taken to gauging the size of Alan Greenspan’s briefcase (Greenspan being the current chairman of the FOMC) as he heads for an FOMC meeting to try to predict the meeting’s outcome: according to them, a fat briefcase means the FOMC will change interest rates, a thin one that rates will stay the same. Greenspan watchers seem to hang on his every word and gesture for clues to the Federal Reserve’s policy direction.
Many people in the United States and abroad, from policymakers to homebuyers, follow Greenspan and the FOMC to get an idea of how the U.S. economy is doing. But many of these watchers have little understanding of what the FOMC is and how it influences monetary policy and thus the economy.
Directing monetary policy
The Federal Reserve Act specifies that the Federal Reserve System and the FOMC, in conducting monetary policy, should seek to promote the goals of maximum employment, stable prices and moderate long-term interest rates.
To meet these goals, the Federal Reserve must balance the flow of money and credit with the needs of the economy. The Board of Governors, the 12 Reserve Banks and the FOMC achieve this balance by influencing the levels of financial institutions’ reserves, which in turn affect the institutions’ ability to make loans or purchase investments. These reserves, required by law of all U.S. depository institutions, must be equal to specified percentages of the institutions’ deposits and can be held either in cash on hand or in account balances at Reserve Banks.
The Fed’s three policy tools for influencing bank reserves are open market operations, the discount rate and reserve requirements. The most flexible, and therefore most important, of these tools is open market operations — the purchase and sale of government securities in the open market. The FOMC directs the Fed’s open market operations, which are carried out by the trading desk of the Federal Reserve Bank of New York.
The FOMC’s policy directives, determined at each FOMC meeting, set a target level for the federal funds rate, which is the rate of interest charged on the use of federal funds. Federal funds are the reserve balances that can be transferred between banks as they try to maintain their reserve accounts at a desired level. Banks with surplus balances may transfer reserves to banks that need to boost their balances. Since many banks use their accounts at Reserve Banks not only to satisfy their reserve requirements but also to clear financial transactions, these banks try to maintain a cushion of funds to protect themselves against unexpectedly large debits that could leave their accounts overdrawn and thus subject to a penalty.
The federal funds rate is highly sensitive to Federal Reserve open market operations, which influence the supply of reserves in the banking system. For example, if the Fed wants to decrease the federal funds rate, it may buy U.S. Treasury securities in the open market, thereby increasing the availability of bank reserves and putting downward pressure on the federal funds rate. To have the opposite effect, the Fed would sell Treasury securities in the open market.
When, where, who?
The law requires that the FOMC meet at least four times a year in Washington, D.C. Since 1980 the committee has held eight regularly scheduled meetings a year, every five to eight weeks. If circumstances call for action between scheduled meetings, FOMC members may attend special meetings or telephone conferences and may vote on proposed actions by telegram or telephone.
The FOMC has 12 members — the seven members of the Federal Reserve Board of Governors and five of the 12 Reserve Bank presidents, one of whom is the president of the New York Fed. The other 11 presidents serve one-year terms on a rotating basis. All of the Reserve Bank presidents attend every FOMC meeting and participate in the discussions, but only the five voting presidents may vote on policy decisions.
By statute, the FOMC determines its own organization. By tradition, at its first meeting each year the committee selects the chairman of the Board of Governors as its chairman and the New York Fed president as its vice chairman. Staff officers for the coming year are chosen from among the officers and employees of the Board of Governors and the Federal Reserve Banks.
Much of the information discussed at FOMC meetings is confidential, so attendance is restricted to the committee members, nonvoting Reserve Bank presidents, staff officers, the manager of the Fed’s open market account, and a few other Board and Reserve Bank staff.
Making informed decisions
Before each scheduled FOMC meeting, the committee members prepare by reviewing a wide variety of information on the economic and financial situation. They consider the economic forecast and the various monetary policy options presented by Board of Governors staff as well as a report, called the Beige Book, compiled by Reserve Bank staff from anecdotal business and economic information in each Federal Reserve District. (The Beige Book is released to the public about two weeks prior to each scheduled FOMC meeting.) The members may also consider other private- and public-sector national economic forecasts.
The committee members also review a report from the manager of the Fed’s open market account on operations in the domestic open market and in foreign currencies since the last regular meeting.
Each Reserve Bank president is typically briefed before each FOMC meeting with his or her staff economists’ forecast for the national economy. Each president may also gather information about his or her region’s economic situation not only from staff but also through contacts with business and community leaders, especially the Reserve Bank’s board of directors.
At the FOMC meeting, staff officers present oral reports on the current and prospective situation in business and in domestic and international financial markets. The reports look at such specific factors as price and wage trends, employment and production, consumer income and spending, residential and commercial construction, business investment and inventories, foreign exchange markets, interest rates, money and credit aggregates, and fiscal policy.
After considering these reports, each Reserve Bank president, whether voting or nonvoting, outlines developments in his or her district. Each governor then makes his or her presentation. After an extended discussion among all members of the appropriate direction for policy, the chairman typically presents a policy recommendation that is open to possible further discussion. Finally, the 12 voting members cast their votes on the policy course to be taken until the next FOMC meeting. Sometimes the members may agree that the recommended policy might need to be modified before the next scheduled meeting.
At the end of the meeting, the committee issues its policy directive to the Federal Reserve Bank of New York, which operates the Federal Reserve’s open market trading desk. The directive indicates the new intended average level of the federal funds rate that the trading desk will try to maintain. The FOMC also makes a public announcement shortly after the meeting that gives this target rate as well a brief rationale for the policy stance.
The minutes for each FOMC meeting are released to the public a few days after the next regularly scheduled meeting; complete transcripts for an entire year of meetings are made available after a five-year lag.
At its first meeting each year, in late January or early February, the FOMC determines its policy objectives for the coming year. The Federal Reserve makes semiannual reports to Congress; in February the FOMC chairman reports on the committee’s expectations about the country’s economic performance and its monetary plans for the current calendar year. In July the chairman reports any revisions to the year’s plans as well as preliminary plans for the next year.