South-Western College Publishing - Economics  
Number 6
Subject Interest Rates
Topic Monetary Policy
Key Words Interest rates, Inflation, Discount Rate, Economic Growth
News Story

In an effort to slow an economy that the Federal Reserve believes has been resistant to previous efforts, the Federal Reserve raised short term interest rates by one-half percent. Furthermore, looking ahead to its June meeting, the Fed's monetary policy committee said that the economy's "risks are weighted mainly toward conditions that may generate heightened inflation pressures in the foreseeable future." In other words, additional rate hikes may be on the horizon.

The Federal Reserve raised the federal funds rate to 6.5 percent, the highest level in 9 1/2 years. The Fed also raised the discount rate to 6 percent from 5.5 percent. The impact of these two moves is to increase a number of short-term interest rates and the borrowing costs for many American households. Home-equity loans, credit card balances and many bank loans are tied directly to the prime lending rates of major banks that generally rise according to the changes that the Fed makes. Rates on home mortgages recently rose to 8.52 percent in anticipation of the Fed rate hike. By raising interest costs, consumer purchases are expected to decrease, resulting in a decrease in aggregate demand.

After five previous increases of one-quarter percent, the Fed decided that a more aggressive approach was needed. The Fed is worried that aggregate demand is rising faster than the nation's ability to increase its production. The Federal Open Market Committee said, "increases in demand have remained in excess of even the rapid pace of productivity-driven gains in potential supply, exerting continued pressure on resources." The rapid pace of expansion has lowered the unemployment rate to 3.9 percent, a 30-year low, and labor shortages will lead employers to grant inflationary wage increases. Over the past year, the economy grew at a 5 percent pace, about 1 to 1.5 percentage points higher than Fed officials believe to be consistent with a stable unemployment rate.

Whether this increase will finally slow the economy is a concern. Many economists believe that future rate hikes will be needed. Others disagree, stating that current levels of inflation-adjusted interest rates have in the past resulted in slower growth.

(Updated June 1, 2000)

Questions
1. Describe the composition and functions of the Federal Reserve Open Market Committee
2. Describe how the Fed's rate increases affects consumers, businesses and financial markets.
3. How would an interest rate increase slow the economy?
Source John M. Berry, "Fed Raises Key Interest Rates," The Washington Post, May 17, 2000.

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