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
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. 

Quotes: Search by Author