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
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