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Fed Orders Interest Rate Cut

Key Economic Concepts:

• Aggregate Demand (AD)
• Deflation
• Federal Reserve
• Federal Reserve Structure
• Fiscal Policy
• Gross Domestic Product (GDP)
• Inflation
• Monetary Policy
• Tools of the Federal Reserve

Description:

On October 15, 1998 Alan Greenspan and the Board of Governors, in a surprise move ordered short-term interest rates cut by 0.25%. What prompted the Fed to take this action? What impact will the rate change have on the economy? Analyze the articles below to examine the linkages between actions of the Federal Reserve Bank and economic performance.

Introduction:

On October 15, 1998 Alan Greenspan and the Board of Governors, in a surprise move ordered short-term interest rates cut by 0.25%. What prompted the Fed to take this action? What impact will the rate change have on the economy? Analyze the articles below to examine the linkages between actions of the Federal Reserve Bank and economic performance.

Resources:

• Fed Cuts Rates by Tame 25 Basis Points:  This article from the Wall Street Journal discusses how the Federal Reserve cut its overnight interest rate by a quarter percentage point in 2003.
  www.marketwatch.com/story/fed-cuts-rates-by-quarter-point ^[1]

Process:

The paragraphs below are excerpted from a Washington Post article "A Tap on the Gas," appearing Sunday, October 18, 1998. Read and answer the questions that follow.

"In easing short-term interest rates another click the other day, Federal Reserve Board Chairman Alan Greenspan made a welcome move in the right direction. Large weak spots have developed in the world economy; some part of the weakness has begun to lap back on U.S. shores. Some politicians in both parties would rather that they be the ones to lift the economy when it flags. For reasons having only partly to do with economic health, they want to vote tax cuts or spending increases. The votes redound to their credit and help them to model the government according to their views as well. A tax cut or a spending increase in the name of stimulus can achieve other social goals at the same time.

But (using the budget to manage the economy) can be a clumsy instrument. Public works programs and other spending programs are often too slow to take effect; by the time the stimulus is felt, the economy is already on the way to recovery. The risks of tax-cutting are likewise high. A government facing the claims that his one does - somehow to squirrel away funds against the retirement of the baby boomers while maintaining national defense and adequate levels of public investment and support for the poor - can ill afford to give up revenue."

•  Identify sections from the article which refer to monetary policy. [paragraph 1]
• Which one(s) refer to fiscal policy? [paragraph 2,3]
• What are the arguments against using fiscal policy to stabilize the economy? [lag between policy implementation and economic effects; tradeoff with tax cuts]
• What does the author mean by "weak spots" in the first paragraph? [Low or no gains in economic output] What aggregate statistic can help identify "weak spots"? [GDP]

In another Post article "Why a 2nd Rate Cut?: Analysts Cite the Need to Calm Debt Markets" appearing on October 17, 1998, author John M. Berry writes:

"Federal Reserve Chairman Alan Greenspan's decision Thursday to cut short-term interest rates so surprised financial markets that yesterday rumors continued to fly that some specific problem, such as the imminent failure of a major bank, must have prompted his action.

Fed officials, who generally prefer moving rates up and down by a quarter-percentage point at a time, did not want to scare already jittery investors and lenders by making a large initial reduction."

•  What impact do jittery investors and lenders have on the US economy? [Answers vary.]
• How might large reduction in interest rates scare investors? [May signal that drastic measures need to be taken in order to buoy economy. There is a danger of self-fulfilling prophecy.]

Read "Fed Cuts Rates by Tame 25 Basis Points ^[1] ."

•  What's the linkage between the Federal Funds Rate and other interest rates? [FFR sends a signal to lenders.]
• What evidence can you find to illustrate the linkage? [Answers vary. Students can check the prime lending rate of major banks before and after the announcement.]
• What other tools can the Federal Reserve use to regulate the economy? [Change reserve requirement ratios (rare); increase/decrease the money supply (uncertain effects on output due to uncertainty about the velocity of money)]

In a statement announcing the drop in the FFR, the Fed said, "Growing caution by lenders and unsettled conditions in financial markets more generally are likely to be restraining aggregate demand in the future further easing of the stance of monetary policy was judged to be warranted to sustain economic growth in the context of contained inflation."

Draw a graph illustrating this scenario.

• What could happen to aggregate output if aggregate demand is "restrained"? [Aggregate output could be "restrained" as well.]

Do you believe the Fed made the right move in deciding to lower the Federal Funds Rate? [Answers vary. Discuss potential for inflation.]

Links Used:

1. ^{^ ^} "www.marketwatch.com/story/fed-cuts-rates-by-quarter-point" - (www.marketwatch.com)

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