South-Western College Publishing - Economics  
The Economy Rocks to Fed Rate Rolls
Subject Interest Rates
Topic Monetary Policy
Key Words Interest Rates, Inflation, Economic Growth
News Story

The Federal Reserve's recent decision to raise short-term interest rates by one-quarter of one percent will have widespread impact on the U. S. economy. Banks will likely increase their prime lending rates by one-quarter percent and this, in turn, will change home equity, credit-card and small business loan rates that are tied to the prime rate. Although long-term rates are not directly subject to Fed control, they have already risen this year, in part because of expectations that the Fed will slow economic growth to restrain inflation, and because of the strong demand for credit. The increase in long term rates will dampen demand in interest-sensitive sectors like housing and business investment.

The Fed's rate hike will affect an average consumer in many ways. Interest on credit card and other consumer installment loans will likely rise. On a $20,000 loan, the quarter-percent increase will add about $50 over a year. Interest rates on 30-year fixed-rate mortgages have already increased significantly this year. The increased rates raise a buyer's monthly payment and higher monthly mortgage payments mean there is less money available for other purposes. Savings will yield higher interest payments. Banks are already paying higher rates on large Certificates of Deposit (CDs) and competition for deposits might raise the rates on small CDs.

The business sector will also feel the impact of higher rates. The recent run-up in longer-term rates has had an impact on corporate borrowing. Some companies have had to pull back planned debt issues and others have had to reduce the amount borrowed. With higher costs of capital, business mergers will be slowed. Capital spending for technology and other investments will also decrease.

Economists estimate that a one-half percent rise in 10-year U.S. Treasury note yields would decrease economic growth by 0.4 percent in a year. Since these yields have risen about 1.3 percent since the beginning of the year, economic growth will likely be 1 percent lower than otherwise.

(Updated August 1, 1999)

Questions
1. Using a demand and supply diagram for money, explain how the interest rate is determined.
2. What instruments are available to the Fed to change the interest rate? Which instrument is most frequently used?
3. If the Fed cannot directly influence long-term interest rates, why have long-term rates increased?
Source John M. Berry, "Consumers Unlikely to Feel Sting of Rate Increase;" The Washington Post, June 29, 1999.

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