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.
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