South-Western College Publishing - Economics  
Fed is Sticking to the Groove
Topic Monetary Policy
Key Words Inflation, Economic Growth and Monetary Policy
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Reference ID: A164542055

News Story The Fed walks a tightrope of sorts in making monetary policy. It must constantly monitor inflation and set policy that keeps it in an acceptable range. For the Fed that range is no more than 1 to 2 percent inflation. If the Fed feels the economy is heating up to a point that will cause unacceptable inflation it will engage in a tight money policy.

Open market operations, carried out by the Federal Open Market Committee (FOMC), are used to control inflation. Most analysts have been expecting an interest rate cut before the end of the year. This would require the Fed to purchase securities in the open market which will increase the reserves in the banking system and lower interest rates. This is referred to as easy money policy.

The benchmark rate is the Federal Funds Rate. This is the interest rate commercial banks charge each other for short-term borrowing of excess reserves. When more reserves are made available through easy money policy interest rates will fall.

Currently the Fed seems to be in a groove, leaving interest rates unchanged at 5.25 percent. Their monetary policy will target and support that level. With many analysts saying the economy was weak, Wall Street has been expecting a rate cut. Bernanke’s speech put that expectation to rest.

“You put it all together, and I think reality kind of hit,” said Ryan Detrick, a senior technical strategist at Schaeffer’s Investment Research. “It definitely looks like the economy is on stronger footing than what people thought a month or so ago. And there probably isn’t going to be a rate cut until later this year – if at all.”

The statement that generated this conclusion came from Bernanke, given to a financial conference in Cape Town. Broadcast via satellite, the Fed chairman said, “Although core inflation seems likely to moderate gradually over time, the risks to this forecast remain to the upside.” In plain English, the statement meant not to expect a rate cut in the near future.

Discussion Questions:
1. Discuss the three tools of monetary policy and how each would be used to fight inflation.
2. Explain the notion of an easy money policy.
Multiple Choice/True False Questions:
1. With an easy money policy the Fed would:
  1. Sell securities in the open market.
  2. Buy securities in the open market.
  3. Raise the prime rate.
  4. None of the above.
2. The federal funds rate is the interest rate:
  1. Banks charge their best customers.
  2. The Fed charges for loans from member banks.
  3. Banks charge each other for overnight loans of excess reserves.
  4. None of the above.
Source Jeremy W. Peters, “Fed Chief Dims Hopes for a Rate Cut”, The New York Times Online, June 6, 2007.
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