South-Western College Publishing - Economics  
When the Fed Speaks, People Listen
Topic Monetary Policy
Key Words Inflation, Economic Growth and Monetary Policy
Full Article

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Reference ID: A160836541

News Story For some time now the Fed has been issuing statements that indicate their bias towards raising interest rates rather than lowering them. As inflationary trends surface in the economy it is the Feds responsibility to stop the trend and produce stable prices. They do this through monetary policy.

When inflation gets too high they have three tools they can use to stop the rising prices. They can change the discount rate, the rate commercial banks pay when they borrow from the Fed; they can change the reserve requirement, the amount of deposits member banks have to hold on reserve; or, they can engage in open market operations which effectively changes the interest rate consumers and businesses have to pay for credit.

The most often used and effective tool is open market operations where the Fed buys or sells securities in the open market to guide interest rates in the desired direction. Lately, with the economy showing signs of inflationary trends the Fed has hinted at increasing interest rates. They have indicated that "additional firming" -meaning rate increases-would continue to depend on the evolving economic outlook.

In its latest statement, the Fed simply referred to "future policy adjustments" which could mean either interest rate increase or decreases. In the end, the Open Market Committee left interest rates unchanged but issued a statement saying, "The committee's predominant policy concern remains the risk that inflation will fail to moderate as expected." To some, this suggested that the Fed's job to fight inflation may not be going as planned.

Also, the economy itself has been subject to some contradictory moves. There is evidence of slowing economic growth while at the same time the economy seems to be experiencing stubbornly persistent inflation. Given these opposing conditions in the economy a decision to increase interest rates to fight inflation would be detrimental to economic growth in an already sagging economy. The Fed's latest statement offers a clue as to how central bank obfuscation will work under Ben S. Bernanke, who succeeded the notoriously ambiguous Allen Greenspan as Fed chairman last year.

Mr. Bernanke has stated that he favors Fed transparency, a tendency toward straightforward language. But at a time when the economy is giving mixed signals, Mr. Bernanke managed to devise a statement that left ample room for interest rates to either increase or decrease in the future by referring to "future policy adjustment. "

Questions
Discussion Questions:
1. Discuss the three tools of monetary policy and how each would be used to fight inflation.
2. Visit http://research.stlouisfed.org/publications/review/03/11/poole.pdf for a discussion of the Fed's transparency. Discuss what is meant by the Fed's transparency.
Multiple Choice/True False Questions:
1. The most often used tool of monetary policy is the discount rate.
  1. True
  2. False
2. To fight inflation, the Fed lowers the interest rate.
  1. True
  2. False
Source Edmund Andrews, "Fed Weighs Words about Its Next Move", The New York Times Online, March 22, 2007.
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