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