South-Western College Publishing - Economics  
Fed Continues to Fight Inflation
Subject Interest Rates
Topic Monetary Policy
Key Words

Federal Funds Rate, Open Market Committee, and Inflation

News Story

The Federal Open Market Committee (FOMC) of the Federal Reserve recently raised the rate on overnight loans between banks by a quarter of a point to a new 2 percent level. The federal funds market operates on the basis of excess reserves. Banks that have excess reserves lend them to banks that need reserves to meet Fed requirements. The federal funds rate has been the focus of the Fed's monetary policy lately as it seeks to signal its concerns about possible inflationary pressures.

In announcing the federal funds target rate increase, the Fed is indicating that it intends to pursue a tight monetary policy. They are describing their action as "accommodative" and "measured." In announcing the decision to raise rates, the Fed statement said, "Output appears to be growing at a moderate pace despite the rise in energy prices. Inflation and longer-term inflation expectations will remain contained."

This emphasis on low inflation pressures indicates that the Fed believes it can continue to take its time in raising rates. Even with the increase, interest rates are still far below historical standards. Yet, some analysts predict economic growth could slow next year and further rate increases could create problems as the Fed seeks to grow the U.S. economy.

"The Fed is in a tough spot," said University of Maryland economics professor Peter Morici. "It has established expectations that it will increase interests rates further and there's a lot of experience showing that it's bad to frustrate expectations. On the other hand, there is evidence that the economy is in trouble."

Alan Greenspan responds by saying that the economy simply entered a temporary "soft patch" during the summer that is nothing to worry about. Fed officials believe they have room to maneuver because the measured inflation rate remains low.

The Fed's preferred measure of inflation-- the Commerce Department's measure for personal consumer expenditures--shows an inflation rate of 1.5 percent.


(Updated January, 2005)

Questions
1.

Define the federal funds rate.

2. How do banks determine if they have excess reserves?
3. Name three tools of monetary policy and how they would be used in a tight money policy.
Source Edmond Andrews, "Fed Raises Interest Rate a 4th Time, to 2 Percent," The New York Times Online, November 11, 2004.

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