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