South-Western College Publishing - Economics  
If At First You Don't Succeed...
Subject Interest Rates, Economic Growth
Topic Monetary Policy
Key Words Interest Rates, Aggregate Demand, Monetary Policy, Recession, Economic Growth
News Story

In a surprise move the Federal Reserve, acting outside of one of its regularly scheduled policy sessions, cut interest rates by one-quarter of one percent. Alan Greenspan, chairman of the of the Federal Reserve, reduced the Federal funds rate to 5 percent and cut the discount rate to 4.75 percent. The Fed's action was in response to growing concern that the unsettled conditions in financial markets will restrain aggregate demand in the future.

The Federal Reserve had cut the federal funds rate by one-quarter percent at its monthly policy-making session just 16 days ago. Many felt at that time that the rate cut was not enough and that the Federal Reserve would cut rates at its two remaining policy sessions this year. The unusual timing of this rate cut suggested that the Fed had information about a deteriorating economic outlook. A statement released by the Fed said, "...further easing of monetary policy was judged to be warranted to sustain economic growth in the context of contained inflation." The rate cut was intended to encourage lending and bring about increased aggregate demand by making it cheaper for consumers and businesses to borrow.

The Fed's action was so much of a surprise that it has led to widespread rumors that it was reacting to some specific problem such as an unpublished failure at a financial institution or investment fund. U.S. financial markets have been unsettled following the near-collapse of the Long-Term Capital Management L.P. hedge fund. Although there is no indication of another problem, Mr. Greenspan has been very concerned and has made public comments about the crisis in the public's confidence in its financial institutions. This decrease in confidence has affected financial markets recently. In the last several months, investors have been dumping stocks and bonds and putting their money into liquid assets such as U.S. Treasury securities. In recent weeks even this safe haven has been affected, with investors eschewing old issues in favor of newer, more liquid ones.

(Updated November 11, 1998)

1. After the Fed cut the Federal Funds rate, major banks responded with a cut in the prime lending rate, the rate banks charge their best customers. What is the impact of this rate change on consumer and business borrowing? How will it affect automobile sales?

2. Describe the effect of the interest rate change on the value of the dollar vis--vis other major currencies.

3. How will U.S. exports be affected by the interest rate change?

4. After the Fed's action, U.S. stock markets increased substantially. Why?

Source Richard W. Stevenson, "Federal Reserve Cuts Rates Again; Wall Street Surges", The New York Times, October 16, 1998.

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