Federal Reserve Interest Rate Changes:
2001-2009

Contents

• Rates Changes
• Understanding the Announcements
• Rationale for Changes

Summary

The Federal Open Market Committee (FOMC) decided at its scheduled meeting, held on April 29, 2009, to leave unchanged the target rate for federal funds, which is now at a range from 0% to ¼%. In doing so, it took notice of its previous decision to add up to $1.75 trillion to the reserves of depository institutions by purchasing agency mortgage-backed securities ($1.25 trillion), agency debt ($200 billion), and Treasury securities ($300 billion). It also repeated that other measures had been adopted to facilitate the flow of credit to households and small businesses. In making its decision, the FOMC stressed that while the pace of the economic contraction appears to have slowed somewhat, the following factors remain: (1) a continuing pattern of job losses, lower household wealth, and tight credit; (2) the decline in global demand is increasing; and (3) while inflationary pressures remain subdued, they may be inconsistent with longer term growth and price stability (meaning that the United States may be facing deflation in the future). Nevertheless, a gradual recovery of sustainable economic growth in the context of price stability is expected to begin, given Fed action to stabilize financial markets and institutions and the monetary and fiscal stimulus now in place. The FOMC pledged to employ all available tools to promote the resumption of sustainable economic growth in a stable price environment. It expects that this will require an exceptionally low federal funds target for some time. The Board of Governors also decided to keep unchanged the discount rate for primary credit at ½%. The next scheduled meeting of the FOMC is set for June 23-24, 2009. This report will be updated as events warrant.

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Federal Reserve Interest Rate Changes:
2001-2009

Rates Changes

The Fed directly changes two interest rates. The first, called the discount rate, is an administered rate explicitly set by the Fed. It is the rate at which the Fed lends short-term funds to banks, pursuant to P.L. 96-221, the Monetary Control Act of 1980. It is determined by the seven-person Board of Governors of the Federal Reserve System. The second, known as the federal funds rate, is a market rate at which banks lend to each other overnight to meet their "reserve requirements " and other liquidity needs. The Fed sets a target for this rate and historically has bought and sold primarily U.S. Treasury securities with an aim to achieving the target, which speedily becomes known to market participants. It is decided by a 12-person Federal Open Market Committee, which includes each member of the board plus a varying five-person roster selected from among the 12 regional Federal Reserve Bank presidents (among the 12, the New York bank is always represented on the FOMC).

On January 6, 2003, the Board of Governors announced a fundamental change to the setting of the discount rate. Henceforth, it was to be made a "penalty" rate for those banks who chose to borrow from the Federal Reserve to meet temporary reserve deficiencies as opposed to borrowing in the federal funds market (the "penalty" aspect of the discount rate comes from the fact that it is set above the target for federal funds). A primary discount rate of 2¼% was initially set for banks judged to be in a sound financial condition, whereas banks whose financial condition was judged to be riskier would be required to pay a higher secondary rate of 2¾%. This change in operating procedure is shown in Table 1. Since the onset of the financial crisis in the summer of 2007, the Fed has not made an issue of whether banks borrow at the discount window or in the federal funds market even though the discount rate remains slightly higher than the target rate for federal funds.

Understanding the Announcements

Because the discount rate is administered, changes in it are stated explicitly and all transactions with the Federal Reserve are at that rate. Hence, the changes shown in Table 1 are the relevant transactions rate. However, because the federal funds rate is market determined, it may vary from day to day or within a day from the announced target set by the FOMC. Thus, the federal funds rates shown in Table 1 are the target rates. Reference to the available financial data may show rates in the federal funds market that vary somewhat from the target in response to shifts in market conditions. At its December 16, 2008 meeting, the FOMC, for the first time, set a range for the federal funds target. This is because it was having difficulty holding the actual federal funds rate at the 1% target rate set on October 29, 2008. For much of the period between that date and December 16, the actual federal funds rate was substantially below the 1% target.

Rationale for Changes

The Fed tries to keep the economy operating at an output level consistent with a low rate of inflation and low unemployment. It therefore seeks a level of interest rates at which the economy will grow at its potential to produce. The interest rate levels consistent with this growth rate vary with the course of the business cycle. Different rates are judged appropriate at different times. Changes in the federal funds target are the most visible signs of shifts in Fed monetary policy stance and they immediately affect financial institutions and markets of all kinds here and abroad. Unusual financial market conditions such as those related to the Asian financial crisis of 1997-1998, the Russian debt crisis of 1998, the terrorist attacks of September 2001, and the financial crisis that began in the summer of 2007 also influence Fed decisions on rate changes. The Fed reports to Congress twice yearly on its monetary policy including rate changes, in oversight hearings in February and July as originally required by P.L. 95-188, the Federal Reserve Reform Act.

Since 2001, the stance of monetary policy has varied considerably. Initially, it was aimed at setting an expansion in motion. To do this, the federal funds target was reduced from 5½% in March 2001 to 1% in June 2003. It remained at 1% for a year. As the expansion gathered momentum, the target was raised gradually to 5¼%, in 17 equal increments spread over two years. Even as the FOMC drew attention to upward movements in the core rate of inflation at various meetings during 2006 and 2007, it continued to express the view that inflation would moderate over time, as would the rate of growth of GDP. These reasons appear to be important for leaving the rate unchanged at 5¼% for more than a year. However, during the late summer of 2007, the fall in housing prices and conditions in financial markets related to the difficulty in refinancing subprime mortgages and extending credit in general became a matter of great concern. To ease these conditions, the Board of Governors on August 17, 2007, reduced the discount rate for primary credit to 5¾%. This was followed on September 18 with another reduction of ½% and a reduction in the federal funds target to 4¾%. Additional cuts of ¼% in both rates were approved on October 31 and December 11, 2007. On January 22, 2008, the target was reduced by ¾% and on January 30 by a further ½%.

The economy began to soften in the third quarter of 2007 (GDP growth was negative, falling at an annual rate of -0.2%). In the first quarter of 2008 it was positive again, and rose at an annual rate of 0.9%. During the second quarter, growth was also positive and at an annualized rate of 2.8%. Unhappily, GDP contracted again in both the third and fourth quarters and, again, during the first quarter of 2009 (it contracted at a 6.3% annual rate during 2008:4 and 6.1% during 2009:1) . The unemployment rate began to rise on a sustained basis beginning in February 2008 and, 13 months later, in March, 2009, it had risen to 8.5% from 4.8%. Job losses since the employment peak in December 2007 are some 5.1 million.

As conditions in financial markets worsened and the economy softened, the FOMC and the Board approved further reductions in the federal funds target and discount rate during 2008. Both rates were lowered on March 18, April 30, October 8, October 29, and December 16, and the discount rate was reduced itself on March 16. They now stand at a range of 0% to ¼% and ½%, respectively. As these developments were taking place, the world price of energy began to rise at a brisk rate. Rising energy prices threatened to boost the overall rate of inflation, posing a challenge to the Fed's mandated commitment to stable prices. Initially, the Fed reacted by holding the federal funds target steady. However, as the magnitude and international scope of the credit crisis became apparent and energy and other commodity prices began to fall, the target was lowered and the Fed undertook a number of new and innovative measures to shore up the financial system and contain the economic contraction. These measures, as well as traditional monetary policy measures, have been unprecedented in their magnitude. During March 2008, the total reserves of depository institutions were $44.3 billion, of which $41.3 billion were required. One year later, total reserves were $780 billion, of which only $55.3 billion were required. Initiatives announced on March 17, 2009, should add nearly $2 trillion to total reserves over the remainder of 2009. The next scheduled meeting of the FOMC is June 23-24, 2009.

For further discussion, see CRS Report RL30354, Monetary Policy and the Federal Reserve: Current Policy and Conditions, by [author name scrubbed].

Acknowledgments

[author name scrubbed] – Economic Policy Consultant, Government and Finance Division contributed to this report.