The Fed and Interest Rates Paper

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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 at least 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.

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