The Fed And Interest Rates Essay, Research Paper

The Fed and Interest Rates

Dave Pettit of The Wall Street Journal writes a daily column that

appears inside the first page of the journal’s Money & Investment

section. If the headlines of Mr. Pettit’s daily column are any accurate

record of economic concerns and current issues in the business world,

the late weeks of March and the early weeks of April in 1994 were

intensely concerned with interest rates. To quote, “Industrials Edge Up

4.32 Points Amid Caution on Interest Rates,” and “Industrials Track On

13.53 Points Despite Interest-Rate Concerns.” Why such a concern with

interest rates? A week before, in the last week of March, the Fed had

pushed up the short-term rates. This being the first increase in almost

five years, it caused quite a stir.

When the Fed decides the economy is growing at too quick a pace, or

inflation is getting out of hand, it can take actions to slow spending

and decrease the money supply. This corresponding with the money

equation MV = PY, by lowering both M and V, P and Y can stabilize if

they are increasing too rapidly. The Fed does this by selling

securities on the open market. This, in turn, reduces bank’s reserves

and forces the interest rate to rise so the banks can afford to make

loans. People seeing these rises in rates will tend to sell their low

interest assets, in order to acquire additional money, they tend move

toward higher yielding accounts, also further increasing the rate. Soon

this small change by the Fed affects all aspects of business, from the

price level to interest rates on credit cards.

Rises and falls in the interest rate can reflect many changes in an

economy. When the economy is in a recession and needs a type of

stimulus package, the Fed may attempt to decrease the interest rates to

encourage growth and spending in the markets. This was the case from

1989 until last month, during which the nation’s economy was generally

considered to be in a slight to moderate recession. During this period

the Fed tried to keep interest rates low to facilitate growth and

spending in hard times. However, when inflation is increasing too

quickly and the economy is gaining strength, the Fed will attempt to

raise rates, as it did late last March. This can be considered a sign

that we are pulling out of the recession, or atleast it seems the Fed

feels the recession of the early nineties is ending.

Directly after the Fed’s actions, the stock market was a mess. The Dow

took huge dips, falling as much as 50 points a day. Although no one

knows exactly what influences the market, the increase in interest rates

played a major role in this craziness. Mr. Pettit’s column on March

25th highlights, “Industrials Slide 48.37,” Mr. Pettit attributes a

large portion of the market’s “tailspin” at this time to, “Rising

interest rates at home.” It is certainly no coincidence that these two

events happened at the same time.

Alan Greenspan, the current chairman of the Fed comes under great

attack and praise with every move the Fed makes. He is, in a sense, the

embodiment of the Fed. He has been in charge of the Fed since 1987.

Some economists blame him for the recession of the early nineties. His

influence on the interest rates as chairman of the Fed is monumental.

It is his combined job as the Fed to steer the economy in a balanced

manner that does not yield too much to inflation and to keep growth

steady. Predictably, most economists are back seat drivers when it

comes to watching the actions of Allen Greenspan, and they tend to feel

they could much more successfully manage the economy than he. Many also

agree with his tactics, so it is a two way street on which the chairman

is forced to drive.

It seems that not only the analysts are in disagreement of how the fed

should operate, but interestingly enough, the internal policy makers

seem to also disagree on what stance the Fed should take. Some of the

internal policy makers are interested in making a more substantial

increase now, while others opt for a more conservative approach, where

the market can be tested for both good and bad influences from the rate

increases. Allen Greenspan is one of this more conservative group, and

it is he is critisized by some for the irradic behavior in the stock

market as of late.

The equilibrium that the Fed is looking for occurs when an interest

rate is set that makes the quantity of real money available be willingly

held. Because this is such a delicate system this “equilibrium” is

never exactly met, and the Fed’s job is to try to keep the market at or

near this form of equilibrium. Unfortunately this case is never exactly

met, and the market can easily suffer because of it.

Summary of Articles:

US News (Late March 1994) -

“Interest Rates: The Fed Strikes Again”

This article covers a brief explanation of exactly what the Fed did,

covering the major factors and influences of the Fed’s actions. It pays

special attention on the issue of inflation, and how different

forecasters will interpret the Fed’s actions. Overall, this article

gives the reader a good understanding of what took place, and what

repercussions are likely to come about because of it.

The Wall Street Journal (Mon. March 28, 1994) -

“Fed Was Divided on Rate-Rise Size Voted in February”

This article shows an interesting perspective of the Fed. It discusses

the fact that the Fed’s policy makers were somewhat split between those

who were looking for a “slight” increase as opposed to one of “somewhat

greater” magnitude. This article is interesting because it shows that

even the Fed can be uncertain about what is best for the economy, but it

still focuses on the power of Allen Greenspan, as well as the committee

as a whole. It compares the two arguments of each method, and shows a

weakness in the Fed that may have been unknown to the reader before.

The Wall Street Journal (Mon. April 11, 1994) -

“Fed Moved Too Slow On Increasing Rates”

This recent article criticizes the Fed’s actions in raising the

interest rate, and complains that the Fed has fallen behind in it’s

job. It discusses the plan for a “Neutral” policy and what the Fed has

tried to do and not do to maintain this so called policy. It argues the

motives and reasons for wanting a lower interest rate and compares past

decades to today’s standings. Overall it focuses deeply on the need to

check inflation and if it is valid. It shows that the Fed tends to take

a more conservative approach to the economy than some analysts would

prefer, but that the Fed will probably continue to raise interest rates.