South-Western College Publishing - Economics  
Interest Rates Head South
Subject Interest Rates
Topic Monetary Policy
Key Words Economic Growth, Interest Rates, Federal Reserve, Federal Funds Rate
News Story

After months of speculating whether the Federal Reserve was going to raise interest rates, the global financial crisis and its theorized effect on U.S. growth caused the Fed in rapid sequence to first consider, and then implement, a decrease in the Federal funds rate by one-quarter of one percent. The Federal Reserve believes that the interest rate cut will stimulate U.S. economic growth and thereby aid foreign economies by keeping export demand strong.

The decrease in the Federal funds rate was the first change since March 1997. The Fed had watched unemployment decrease steadily to 4.5 percent, a 25-year low, and was carefully monitoring economic data for signs that the tightening labor market would cause upward pressure on wages and thereby inflation. Its quandary had been whether to raise interest rates and slow growth in anticipation of growing inflation or continue to let the economy grow at rates the Fed felt were unsustainable. In the last several months there have been increasing signs that the economy is slowing because of the weakened Asian and Russian economies. These changes caused the Fed to rethink its decision.

Lowering the Federal funds rate -- the rate on overnight loans between banks -- should provide additional funds to the banking system and protect the economy from a potential credit contraction such as might occur from the collapse of a major bank or credit center. The Fed left unchanged the other rate it controls: the discount rate. The impact of these changes on consumers should be a further decrease in interest rates, such as mortgage rates. Lowered U.S. interest rates should reduce the flow of capital to the U.S. If funds from other countries stay at home they will be available for domestic investment and thereby have the potential to strengthen the domestic economy. Rate cuts will also weaken the dollar, helping businesses and governments in other countries to repay their dollar denominated debts.

Many economists believe that this rate cut was not large enough and additional cuts will follow. The Fed's policy panel will meet twice more this year to evaluate the impact of this rate cut and consider other options. (Updated October 15, 1998)
Questions

1. What is the Federal funds rate?

2. How can the Federal Reserve bring about a decrease in interest rates?

3. What is the impact of a reduction in U.S. interest rates on the U.S. foreign exchange rates?.

4. What is the consequence of a depreciation of the dollar on U.S. exports and import?
Source Richard T. Stevenson, "Federal Reserve Lowers Key Rate By Quarter-Point," The New York Times, September 30, 1998

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