The Economy Rates a 10
Subject Stabilization Policy
Topic Monetary Policy
Key Words Recession, Inflation, Economic Growth, Employment
News Story

In the face of a faltering economy with surging joblessness and slumping consumer confidence, the Federal Reserve cut the federal funds rate by one-half percent in an effort to inject some strength into the economy. The interest rate cut to 2 percent, the tenth rate cut in 2001, brings interest rates to their lowest levels in 40 years. “Heightened uncertainty and concerns about a deterioration in business conditions both here and abroad are dampening economic activity," the Fed said. The Fed also said, "the long-term prospects for productivity growth and the economy remain favorable and should become evident once the unusual forces restraining demand abate.”

While there was widespread belief that the Fed would cut interest rates, the magnitude of the cut was uncertain. Many analysts had argued for a moderate cut of one-quarter point instead of the more aggressive cut of one-half percent. They argued that the Fed, in bringing the Federal funds rate down to 2 percent, had not left itself a safety margin should another economic shock occur. Another reason for not cutting interest rates significantly, they argue, is that the effects of tax cuts and increased federal spending in stimulating the economy had not been properly considered. Too much stimulus might cause long-term interest rates to rise as bond traders anticipate the consequences of low interest rates in producing inflation. Support for a one-half percent cut was aided by the Labor Department's October employment report of the largest monthly job loss in more than two decades.

The 10 rate cuts so far this year have not prevented the economy from declining. In the past, recessions were typically the result of Federal Reserve policy to prevent inflation by raising interest rates and slowing the economy. When that was accomplished, the Fed would lower interest rates and the economy would reverse its course. In contrast to previous downturns, this decline was initiated by cuts in business spending followed by a large stock market sell–off.

(Updated December 1, 2001)

1. What is the federal funds rate? Consumers, it is argued, will benefit from a decrease in the federal funds rate. Explain.
2. What is the risk of cutting interest rates too much? Explain.
3. What is the difference between the nominal and real interest rate? Can the real interest rate ever be negative? Explain. Can the nominal interest rate ever be negative?
Source Louis Uchitelle, "Fed Reduces Short-Term Rates to Lowest Level Since 1961," The New York Times, November 7, 2001.

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