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...
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