South-Western College Publishing - Economics  
A Cutting Problem
Subject The Fed and Interest Rates
Topic Monetary Policy
Key Words Business Cycle, Interest Rates, Inflation
News Story

There is always much discussion and debate about the appropriate course of action for the Federal Reserve. When the Federal Reserve holds its monthly meeting to determine whether current economic conditions require a revision of the Fed's monetary policy, there will no doubt be debate over whether the Fed should cut interest rates again or simply hold the line. We take it for granted that the Fed's deliberations and decisions are very important, but are they?

One of the problems for the Fed in determining an appropriate course of action is that the Fed is never sure of where we are in the business cycle and where we are headed. Furthermore, there are limitations to the impact of Fed policy. The Federal Reserve cannot control long-term interest rates, employment, prices, or consumer spending. The Fed's only leverage is an adjustment in short-term interest rates and the relationship between short-term rates and these important variables is not precise. Because of these limitations, deliberation over the course of monetary policy involves a lot of guessing or balancing of risks.

Proponents of rate cutting point to evidence that the economy is slowing. For example, employment in manufacturing and export sales has decreased. The Fed's previous cuts were directed at calming financial markets. Using as a measure of investor fear the difference between the corporate and government borrowing rates, the Fed's actions were somewhat successful. The gap decreased but still remains above historical trends.

There is an argument for not cutting rates. Rising stock prices and still low unemployment rates mean that there is still an inflationary threat. The Fed has in the past been guilty of overstimulating the economy.

(Updated December 1, 1998)
Questions

1. What are the instruments of monetary policy?
2. What is the composition of the Federal Reserve's Open Market Committee?
3. Suppose that the Federal Reserve wanted to lower interest rates, what actions could the Fed take to bring that about?
4. What impact would lowered interest rates have on the economy?

Source Michael M. Weinstein, "Why Rates Should Be Cut, and Why Not", The New York Times, November 12, 1998.

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