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Inside The Vault - Spring 2011
Inside The Vault - Spring 2011
Issue 1
Spring 2011
A n E c o n o m i c E d u c at i o n Ne w s l e t t e r f r o m t h e Fe d e r a l Re s e r v e B a n k S t. L o u i s
In January 2008, the FOMC projected that has a natural rate of interest that depends
the unemployment rate in the fourth quarter on factors such as the nation’s saving and
What’s Your of 2010 would average 5 percent. But by the investment rates. When economic activ-
Question? end of 2008, with the economy in the midst ity weakens, monetary policymakers can
Inflation and of a deep recession, the unemployment rate push the interest rate target (adjusted for
Deflation had risen to about 7.5 percent; a year later, it inflation) temporarily below the economy’s
reached 10 percent. natural rate, which lowers the real cost of
The Fed used a dual-track response to the borrowing. To most economists, the primary
Economic recession and financial crisis. It adopted benefit of low interest rates is their stimula-
Snapshot some unconventional policies, such as the tive effect on economic activity. By reducing
CPI and purchase of $1.25 trillion of mortgage-backed interest rates, the Fed can help spur business
Core CPI securities. And the FOMC reduced its inter- spending on capital goods—which also helps
est rate target to near zero in December the economy’s long-term performance—and
2008 and indicated its intent to maintain can help spur household expenditures on
Bulletin Board a low interest rate environment for an homes or consumer durables like automo-
Third National “extended period.” Recently, some econo- biles. For example, home sales are generally
Economic Education mists have begun to discuss the costs and higher when mortgage rates are 5 percent
benefits of maintaining extremely low short- than when they are 10 percent.
Video Competition
term interest rates for an extended period. A second benefit of low interest rates is
improving bank balance sheets and banks’
Resources Benefits of Low Interest Rates capacity to lend. During the financial crisis,
The Economic In a market economy, resources tend to many banks, particularly some of the largest
Lowdown flow to activities that provide the greatest banks, were found to have too little capital,
returns for the risks the lender bears. Inter- which limited their ability to make loans dur-
est rates (adjusted for expected inflation ing the initial stages of the recovery.
and other risks) serve as market signals of By keeping short-term interest rates
www.stlouisfed.org/education these rates of return. Although returns will low, the Fed helps recapitalize the banking
differ across industries, the economy also continued on Page 2
T h e f e d e r a l r e s e r v e b a n k o f s t. l o u i s : C e n t r a l t o A m e r i c a’ s e c o n o m y ®
Low Interest Rates
continued from Page 1
system by helping to raise the industry’s net interest Costs of Low Interest Rates
margin (NIM), which boosts its retained earnings
Just as there are benefits, there are costs associ-
and, thus, its capital. Between the fourth quarter
ated with keeping interest rates below the natural
of 2008, when the FOMC reduced its federal funds
level for an extended period. Some argue that the
target rate to virtually zero, and the first quarter of
extended period of low interest rates (below the
2010, the NIM increased by 21 percent, its highest
natural rate) from June 2003 to June 2004 was a key
high low
contributor to the housing boom and the marked
increase in household debt relative to after-tax
rate of
return
Interest
real federal funds rate below the economy’s natural
interest rate. For example, some point to the 1970s,
when the Fed did not raise interest rates fast enough
or high enough to prevent what became known as
the Great Inflation.
deflation Fed
investors
Other costs are associated with very low inter-
est rates. First, low interest rates provide a powerful
mortgage
incentive to spend rather than save. In the short term,
Funds this may not matter much, but over a longer period,
low interest rates penalize savers and those who rely
$
inflation
Credit
www.stlouisfed.org/education_resources 2
move in opposite directions), exposing banks to substantial losses. period” may lead to a Japanese-style deflationary economy. This
Second, low short-term interest rates reduce the profitability of might occur in the event of a shock that pushes inflation down to
money market funds, which are key providers of short-term credit extremely low levels—maybe below zero. With the Fed unable to
for many large firms. (An example is the commercial paper mar- lower rates below zero, actual and expected deflation might per-
ket.) From early January 2009 to early August 2010, total assets of sist, which, all else equal, would increase the real cost of servicing
money market mutual funds declined from a little more than $3.9 debt (that is, incomes fall relative to debt).
trillion to about $2.8 trillion.
Finally, St. Louis Fed President James Bullard has argued that Kevin Kliesen is an economist at the Federal Reserve Bank of St. Louis.
the Fed’s promise to keep interest rates low for an “extended
Asset – Anything an individual or business owns that has com- Interest rate – The price of using credit expressed as a per-
mercial or exchange value. centage of the amount owed.
Board of Governors – Central governmental agency of the Investment – The purchase of new capital resources; the diver-
Federal Reserve System located in Washington, D.C., and sion of resources from the production of goods and services
composed of seven members appointed by the president and for current consumption to the production of goods and
confirmed by the Senate. services that increase the economy’s productive capacity.
Borrowing – Receiving something on loan with the promise or Loans – Money provided temporarily on the condition that the
understanding of returning it or its equivalent. amount borrowed, will be repaid, usually with interest.
Capital goods – Manufactured goods—such as machines, equip- Market economy – An economy that allocates resources
ment, and structures—that are used to produce other goods through the decentralized decisions of many firms and house-
and services. holds as they interact in markets for goods and services.
Deflation – A general downward movement of prices for goods Monetary policy – A central bank’s actions involving the
and services in an economy. use of interest rate or money supply tools to achieve
economic goals.
Federal funds rate – The interest rate charged by a bank on an
overnight loan of funds to another bank. Net interest margin (NIM) – The difference between the
interest expense a bank pays (cost of funds) and the interest
Federal Open Market Committee (FOMC) – A Committee income a bank receives on the loans it makes.
created by law that consists of the seven members of the
Board of Governors; the president of the Federal Reserve Bank Rate of return – Also called the “yield,” this is the return on an
of New York; and, on a rotating basis, the presidents of four investment expressed as a percentage of its price.
other Reserve Banks. Nonvoting Reserve Bank presidents also Recession – A period of declining real income and rising unem-
participate in Committee deliberations and discussion. ployment; significant decline in general economic activity
Federal Reserve System (FED) – The central bank of the extending over a period of time.
United States. Risk – Exposure to loss of investment capital due to a variety
Incentives – Perceived benefits that encourage certain of causes, such as business failure, stock market volatility,
behaviors. and interest rate changes; in business, the likelihood of
loss or reduced profit; the danger or probability of loss to
Inflation – A general, sustained upward movement of prices for an individual.
goods and services in an economy.
Unemployment rate – The percentage of the labor force that
Inflation rate – The percentage change in the price index from is willing and able to work, is not currently employed, and is
a previous period. actively seeking employment.
Interest – The price of using credit—that is, someone else’s Yield – The return on an investment, stated as a percentage of
money—to make purchases. the price. Also called rate of return.
3 www.stlouisfed.org/education_resources
w h a t ’ s y o u r question ?
Q. The Fed’s policymaking body, the Federal Open items until the price was as low as possible. Delayed
Market Committee, usually targets the federal spending results in fewer sales and less revenue
funds interest rate to conduct monetary policy. In for businesses, which in turn reduces the need for
response to economic conditions, the FOMC acted employees and thereby increases unemployment.
to reduce that interest rate to near zero in Decem- Another factor to consider is the cost of credit dur-
ber 2008. Did the Federal Reserve substantially ing deflationary times. Since the value of money
lower the rate in previous recessions? increases in a deflationary environment (each dollar
A. Yes. In the graph of the federal funds rate (below), will buy more goods and services), debtors must
the shaded bars represent recent U.S. recessions. repay their old loans with more-valuable dollars, to
In these recessions, the federal funds rate dropped the benefit of their creditors.
as a result of the Fed’s policy actions. However, Q. What specific goods and services are
the past recession was the only one where the rate represented in the CPI’s market basket of
approached zero. consumer goods?
Effective Federal Funds Rate (FEDFUNDS) A. The CPI is often referred to as the “all items
Source: Board of Governors of the Federal Reserve System index.” Although it does not include literally all items,
20.0 it includes a representative selection of consumer
17.5 goods and services. Items are divided into more than
15.0 200 categories, arranged into eight major groups:
Percent of Change
www.stlouisfed.org/education_resources 4
e c o n o m i c snapshot
0.2
while Graphs A and B show greater differences and vari- -0.1 CPIAUCSL
ances. This is because Graph C looks at the long-term -0.0 CPILFESL
trend, and while the differences in the measurements on -0.1
the first two graphs appear substantial, over the long run -0.2
the trends for both the CPI and the core CPI are quite -0.3
2010-01 2010-04 2010-07 2010-10 2011-01 2011 research.stlouisfed.org
similar. Graphs showing longer time spans will reflect
the long-run picture, whereas those with shortened time Graph B
spans will reflect short-term trends.
Consumer Price Index for All Urban Consumers: All Items (CPIAUCSL)
Consumer Price Index for All Urban Consumers: All Items Less Food & Energy (CPILFESL)
4. Which graph would be best for finding the 4
following types of information?
3
1. The number of recessions over the past 50 years
Percent of Change
Graph C
Consumer Price Index for All Urban Consumers: All Items (CPIAUCSL)
Consumer Price Index for All Urban Consumers: All Items Less Food & Energy (CPILFESL)
15.0
12.5
10.0
Percent of Change
7.5 CPIAUCSL
5.0
CPILFESL
2.5
0.0
-2.5
1940 1950 1960 1970 1980 1990 2000 2010 2020 2011 research.stlouisfed.org
Answers: 1.-C; 2.-A; 3.-C; 4.-A; 5.-B and C;
Shaded areas indicate U.S. recessions
5 www.stlouisfed.org/education_resources
bulletin b o a r d
a l l l ocatio n s memphi s
For more information on any of the following events, go to Contact: Jeannette.n.bennett@stls.frb.org
http://stlouisfed.org/education_resources/events/ unless
otherwise indicated. Personal Finance Two-Day Workshop
for Tennessee Educators
Third National Economic Education
Video Competition Location: Agricenter International, Memphis, TN
June 1-2, 2011
April 18 deadline
For more information: http://stlouisfed.org/education_
Focus on the Economy
resources/videocontest.cfm
http://www.mscee.org/focus_signup.php
Jackson, MS
A Webinar: Fiscal and Monetary Policy
June 1-3, 2011
April 20, 3:30 - 4:30 CST
Dollars and Sense in the Classroom
Economics and Children’s Literature K-4
Ittabama Community College
July 7, 8:30 - 3:30 CST Tupelo, MS
June 15, 2011
Insights from the Inside
July 14, 8:30 - 3:30 CST Integrating Economics in the
Mississippi Classroom
Economics and Children’s Literature 5-8 Ittabama Community College
Tupelo, MS
July 21, 8:30 - 3:30 CST
June 22, 2011
Contact: Barbara.flowers@stls.frb.org
Cards, Cars and Currency
AP Economics Program
July 27, 8:30 - 3:30 CST
June 16 and 17, 8:30 - 3:30 CST
Time Value of Money / It’s Your
Paycheck!
July 28, 8:30 - 3:30 CST
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bulletin b o a r d
Bank Contacts
Little Rock
Pam Haynie
501-324-8205
AP Economics Program
Louisville
Caryn Rossiter
502-568-9257
Memphis
Jeannette Bennett
8:30 a.m. - 3:30 p.m. | Thursday, June 16, 2011 901-579-4104
8:30 a.m. - 3:30 p.m. | Friday, June 17, 2011 - Conference registration includes both days.
St. Louis
Mary Suiter
Are you a seasoned AP economics instructor? Have you thought about teach- 314-444-4662
ing AP economics? Is your school or district interested in adding AP economics Barb Flowers
courses to its curricula? 314-444-8421
Scott Wolla
If the answer to any of these questions is yes, please join us for a two-day workshop at the Fed-
314-444-8624
eral Reserve Bank of St. Louis. Federal Reserve staff and experienced AP instructors will demon-
strate engaging economics lessons and introduce interactive whiteboard applications developed
specifically for AP classes in micro and macro.
The workshop will include whole-group discussions of best practices, course development, and
textbook selection. An “Ask the Expert” panel will delve into those thorny content problems,
offering ideas for alternative instructional approaches.
Participants receive:
• certificates of completion
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f e a t u r e d resources
The Economic Lowdown is available on the Federal Reserve Bank of St. Louis’s website,
www.stlouisfed.org/education_resources/podcasts
and on iTunes.
www.stlouisfed.org/education_resources
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