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The fed and interest rates

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.

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