South-Western College Publishing - Economics  
Rates Happen
Subject Interest Rates
Topic Monetary Policy
Key Words Interest Rates, Inflation, Economic Growth
News Story

At every meeting, the Federal Reserve Open Market Committee discusses the future direction of interest rates. Investors, economists and the general public anxiously await the outcome of these meetings. At the Federal Reserve's September meeting, the Fed decided to leave interest rates unchanged and most investors probably heaved a sigh of relief. However, looking at the yield on United States Treasuries since that time, it is obvious that yields have been increasing. This raises the question: if the Fed didn't raise rates, why are rates rising? The answer is that there have been a number of changes in the demand for and supply of financial assets.

One important factor was rising fears of inflation brought about by increased oil and gold prices and economic reports that suggested that the economy had not slowed. The National Association of Purchasing Managers' index - a measure of activity in the nation's industrial sector- had an unexpectedly strong rise in September. The index of prices paid by factories also rose to its highest level in more than four years.

Fears of interest rate hikes cause bondholders to want to sell their bonds. Increased bond selling was also the result of foreign investors dumping U.S. Treasuries because of the increases in the U.S. dollar, especially in relation to the yen. Miniscule interest rates in Japan attracted investors who borrowed funds and used the proceeds to buy U.S. Treasuries. As the yen increased in value, the black ink turned red and caused these bonds to be sold.

Investors also bet on interest rate movements through interest rate swaps, in which one investor agrees to exchange a fixed rate for a floating rate. Interest rate swaps are the basis for 80 percent or more of derivatives held by American banks. As interest rates increase, these derivatives become questionable.

(Updated November 1, 1999)

Questions
1. Using a demand and supply diagram for money, explain how the interest rate is determined.
2. How can the Federal Reserve bring about a change in the interest rate?
3. Suppose that interest rates abroad were to rise and foreign investors sold their holdings of U.S. Treasuries in order to buy foreign securities. Using a supply and demand curve for U.S. Treasuries, show the impact of this decision on the price of bonds. What is the corresponding change in the interest rate on these securities?
Source Gretchen Morgenson, "Even if the Fed Is Idle, Rates Are on the Rise," The New York Times, October 3, 1999.

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