Imagine the inflation rate begins to rise rapidly, the FOMC meets and it is believed that the target interest rate needed to stem the inflation could easily exceed 20 percent. Many members of the committee believe the Fed cannot announce this high of a target for political reasons. Discuss what the FOMC could do in terms of targets and what change occurred in 2002 that is going to make their job a bit more difficult.

Question

What will be an ideal response?

Answer 1

One thing the FOMC could do is instead of an interest rate target, they could set a quantity target, such as reserves or the monetary base. By doing this they do not explicitly announce a high interest rate target and can escape the responsibility for the high rates. In 2002 discount lending policy was altered to where banks can borrow primary credit from the Fed at a rate 100 basis points over the target federal funds rate. The Fed would have to announce that they are no longer targeting the federal funds rate and then possibly alter the discount lending policy to be 100 basis points over the market federal funds rate (or some average of the market rate over a period of time), or if they leave a target rate in place that turns out to be too low relative to the market rate so banks borrow heavily from the Fed, they will have to withdraw reserves from the system as banks are borrowing them using open market operations.