Federal Reserve and Expectations
Fox News reported in May 2006 that Federal Reserve policymakers had raised the funds rate in the face of an expected increase in inflation. Given that raised rates of interest are expected to reduce consumer spending as well as capital investment, thereby reducing demand as well as prices, the Federal Reserve hoped to control inflation through the use of its primary tool of influencing economic activity, i.e. the funds rate or the interest that banks charge each other on overnight loans, which affects several other interests rates charged to consumers and to businesses (Associated Press). Hence, whenever the Federal Reserves expects the rate of inflation to rise, the economy can expect a raise in interest rates. The increase in interest rates is in turn expected to slow down economic activity in the nation. While slowing down economic growth is not a good idea, economists believe that high inflation could get even worse. Therefore, by controlling an expected increase in inflation, the Federal Reserve attempts to save the economy from the dire effects of inflation. If the Fed would rather wait for high inflation to set in before it takes measures to control it, i.e., if the Fed only acts to control the current high inflation rate, the economy may suffer drastically because it might be too late to help the economy in a significant way.
On the contrary, whenever the Federal Reserve expects a recession to set in, its policymakers will reduce the rates of interest in order to make it more attractive for consumers to make purchases, and for businesses to invest in capital. However, dramatic declines in interest rates do not always lead to increases in spending and investment. In May 2002, USA Today reported that this is exactly what had happened in the American economy. Reduced interest rates did not increase spending and investment. Instead, they reduced the interest income of American families, thereby hastening the onset of recession or economic retardation (Kane). Of course, the recession and the low interest rates were accompanied by the inverted yield curve. This is because long-term investors had settled for lower yields by assuming that the economic growth as well as rates of interest were going to go even lower in the future (The Living, 2002).
The investors act on expected rates of inflation and economic growth, also the economic factor of unemployment besides other factors. The Fed does the same. However, expectations may not always be correct. This is the reason why the Fed’s policies could sometimes fail to yield desired effects, whether they concern inflation or unemployment.
1. Associated Press. (2006, May 31). “Federal Reserve Minutes Show Uncertainty Over Future Interest Rate Hikes.” Fox News. Retrieved from http://www.foxnews.com/story/0,2933,197674,00.html. (20 February 2007).
2. Kane, Tim D. (2002, May). “Behind Alan Greenspan’s recession: the Federal Reserve Chairman’s “attempt to head off recession through lower interest rates not only failed to prevent it, but actually slowed the economy’s pace.” USA Today.
3. “The Living Yield Curve.” (2007). One Bond Strategy. Smart Money. Retrieved from http://www.smartmoney.com/onebond/. (20 February 2007).