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FEDERAL RESERVE POLICY.
Term Paper ID:24544
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Essay Subject:
Intended goals of Reserve's interest rate changes & impact on stock market, prices & wages, inflation & business decisions.... More...
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8 Pages / 1800 Words
8 sources, 16 Citations,
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Paper Abstract:
Intended goals of Reserve's interest rate changes & impact on stock market, prices & wages, inflation & business decisions.
Paper Introduction:
Absent the presence of special factors, interest rates drive the stock market. Monetary policy is the government's most versatile policy tool. Through adjustments in bank reserves, and thus loanable funds, Federal Reserve Bank policymakers can influence interest rates (the cost of money and credit). The ultimate impact of these adjustments is on economic activity. When interest rates increase, economic activity is curtailed. Conversely, when rates decrease, economic activity expands. Since stock market growth is fueled, in part, by business expansion, market analysts pay close attention to every move made by Federal Reserve Board Chairman Alan Greenspan.
The Federal Reserve policymakers target a desired rate of money growth. This targeting is reflected in the movement of the federal funds rate (the rate on reserves loaned and borrowed
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Through adjustments in bank reserves, and thus loanable funds,Federal Reserve Bank policymakers can influence interest rates (the cost ofmoney and credit). The market rebounded in the UnitedStates as well as Asia, but investor confidence was shaken. This downtown beganin 1981 and was accompanied by an excessively high jobless rate. In Sarkis Khoury (Ed.) Recent Developments inInternational Banking and Finance (pp. Inflation fell to around 4 percent in1983 and remained steady thereafter. . A2). Beyond the markets, Asia'swoes will exact a toll on many lands. Unemployment reached the double digitlevel and the stock market reacted accordingly. So resources are misallocated" ("On the Trail," 1997,p. Since stockmarket growth is fueled, in part, by business expansion, market analystspay close attention to every move made by Federal Reserve Board ChairmanAlan Greenspan. When there is too much money inthe real economy (caused by low unemployment) demanding too few goods (theresult of decreased productivity), the stage is set for price inflation.Low unemployment is usually accompanied by wage increases, anotherforerunner of inflation but the economy appears to be shrugging offemployment gains, "[Greenspan] is heartened that the economy was able toswallow a hike in the federal minimum wage without so much as aninflationary hiccup" (Foust, 1997, p. Japan, already reeling from a weak economy at home, has felt theforce of the free fall of the economic turmoil in Southeast Asia. According to one expert, "Japaneseinstitutional investors [may] have to liquidate some portion of their hugeU.S. Timberlake, R. As oneexpert puts it, "The economy seems to be moving off the maps as we knowthem" (Miller, 1997, p. Traditionalwarning signs of inflation have been an irrationally high rate of economicgrowth and a low rate of unemployment. Theeconomy stalled badly in 1974-1975. Nevertheless,the challenge of setting monetary policy is more a science than an art:"To say that central-bank policy is an 'art' and subject to interpretativejudgments is to deny to it the best scientific analysis" (Timberlake, 1993,p. The ultimate impact of these adjustments is on economicactivity. Early in1983, however, an economic rebound became obvious, initiating the greatbull market of the 198 s. It behooves corporate managers to pay attention to interest ratetrends. Greenspan has long bemoaned the Federal Reserve's reliance on weakstatistics that fail to evaluate changes in the new economy. . (May 26, 1997). A buying bingeresulted, not only among consumers but also in the real estate, financial,and corporate sectors. Corporateuncertainty tends to inhibit investment because efficient businessoperations require advanced planning: "To plan production and sales, firmsset prices and agree with workers on employment and real wages one periodat a time" (Brunner, Cukierman, and Meltzer, 1989, p. A sustained increase in interest rates hurts the stock marketin two ways. The avoidance of this scenario constitutesthe core of Greenspan's philosophy, reiterated at a recent annual symposiumof the Federal Reserve: "The central bankers stuck to their view thatprice stability is the only appropriate long-term goal for monetary policy"("Shoot," 1996, p. Monetary policy in the United States.Chicago: University of Chicago Press. Consumers were encouraged by tax cuts, declines in interestrates, and evidence that inflation had been tamed at last. Economic growth is a function ofgrowth of the labor force and growth in productivity. . The FederalReserve discount rate also tends to follow these other rates albeit oftenwith a lag. 5 ). Wysocki, Jr., B. Stock market analysts fear that Japan's mounting troubles will prompta sell-off of financial assets. 5 ). The unemployment rate stands at under five percent, thelowest it has been in decades. Another characteristic is an unprecedented degree ofparticipation by Americans in the stock market, either through their ownstock holdings or those of their pension plans. While manufacturingactivity is amenable to measurement, service-sector activity is not:"Economists and Fed officials agree that hard-to-measure service-sectoroutput is so understated that overall productivity could be low-balled byas much as half a percentage point" ("Shoot," 1996, p. On the trail of the mutant inflation monster. stock market in that year. 193-229). This harsh approach, in conjunction with a sharp drop inworld oil prices, proved successful. 77-78). 46). A depressing influence on stock prices occurs shortlythereafter. The new economy is characterized by increasedeconomic interdependency among global trading partners, low unemployment,and stable prices. Consumer spending onhousing purchases and other "big ticket" items like automobiles alsofluctuate based on the government's monetary policy: "Fed action oninterest rates will affect the jobs, loans, and mortgages of millions ofcitizens and companies" (Miller, 1997, p. Sorry, Alan, wrong number. Shoot to kill? Gerald Ford's presidency was characterized by severe recession. (November 1 , 1997). Consequently, Greenspan studiouslyscrutinizes various research reports and business indicators. When interest rates increase, economic activity is curtailed.Conversely, when rates decrease, economic activity expands. Corporate managers must consider whetherinventories should be reduced or replaced, wage rates adjusted, etc. 46). In late 1997,a collapsing market in Hong Kong reverberated around the globe and caused asharp drop in the U.S. 46). Greenspan keeps such a close watch on inflation because efforts tocurb it after the fact usually prove fruitless. Foust, D. Just what the chairman ordered.Business Week (p. Therate of inflation continued to go up, but economic growth declined andunemployment soared. Treasury holdings--a development that would tend to drive up U.S.interest rates" (Wysocki, Jr., 1997, p. Andeconomists believe that other official statistics are equally unreliable:"Alan Greenspan . 5 ). U.S. 73-75). Money and economicactivity, inventories and business cycles. Another unsettling economic trend for the Federal Reserve is theunemployment rate. stock market. Ronald Reagan's administration took an active role in fightinginflation. (October 4, 1997).Economist (pp. (September 7, 1996). Greenspan closely monitors the Asianfinancial markets, and testified to Congress recently that the spillovereffect of the Asian crisis raised concern for the United States. But the high interest rates necessaryto curb inflation again resulted in severe recession. Greenspan has repeatedly made it clear that the goal of the FederalReserve is price stability. Greenspan has since usedall available means to prevent the repeat of a similar speculative bubblein the stock market. Oxford, UK: BasilBlackwell. (October 3 , 1997). The Federal Reserve policymakers target a desired rate of moneygrowth. Then, in late 1987, came the "Black Monday," stockmarket crash, the biggest single-day drop in stock market history. Although this scenario isunlikely, foreign investors pulling back from U.S. Tax receipts dropped asbusiness stagnated and the federal deficit rose to record levels. Miller, M. 49-5 ). Thespeed of response to uncertainty varies depending on the type of businessinvolved and the economic information the business has access to: "It istrickier to spot changes in relative prices if the general price level isrising rapidly . longer-term bondinvestments in early 1987 was a contributing factor to the crash of theU.S. Regardless of the length of time for evaluation, a period ofinvestment stagnation ensues. The Federal Reserve led the charge, pushing the discount rateever higher. Mere rumorsof a proposed move by the Federal Reserve to raise or lower interest ratescan result in volatility in all major financial markets: "Even in a highlycompetitive market, characterized by high volumes and operating on a globalscale, personal contacts and reputations of individual traders and managersplay important roles" (Burnham, 1991, p. Corporate managers must also attune themselves to changes in foreignmarkets since they tend to influence the U.S. Economists believe that if the unemploymentrate continues to remain low, inflation is sure to follow. (1989). One ofAmerica's second largest trading partners, Japan has depended heavily onexports to support its own weak growth: "The Japanese economy is in thedumps, the deficit is climbing, and the banks are still mired in crisis"(Wysocki, Jr., 1997, p. 411).Movement in the cost of overnight funds triggers movement in more publiclyvisible rates such as the prime and the Treasury bill rate. Absent special factors such as wars or natural disasters, the FederalReserve's policy of price stability remains intact. Nixon subsequently vacillated fromone policy to another in a futile effort to curb inflation and cure therecession: "Federal Reserve anti-inflation steps have historically cometoo little, too late" (Miller, 1997, p. Current structure and recent developments inforeign exchange markets. Conversely, under mostcircumstances, a decline in the federal funds rate will exert downwardpressure on bond yields and, in turn, spark an increase in stock prices.Stock market participants conclude that lower rates not only improve thecompetitiveness of stocks relative to money market instruments and bonds,but also eventually stimulate economic activity and profits. 75). Despite their stock market rebounds, Asian markets remain troubled.Thailand, Malaysia, and Indonesia have recently experienced severe currencycrises. Burnham, J. (1991). stock market. 77). Monetary policy is the government's most versatile policytool. This targeting is reflected in the movement of the federal fundsrate (the rate on reserves loaned and borrowed among banks, usuallyovernight). Thecrash reminded investors that the stock market can go up as well as downand had a lasting effect on Greenspan: "When the stock market crashed in1987, Federal Reserve Board Chairman Alan Greenspan--just two months on thejob--went into crisis mode" (Foust, 1997, p. Uncertaintyabout the true rate of productivity growth has prompted the Federal Reserveto retain its fear of inflation. For instance, if the action of the Federal Reserve results in an increasein the federal funds rate and other money market rates, upward pressure onbond yields occurs. 213). Absent the presence of special factors, interest rates drive thestock market. 73). Nixon encouraged the FederalReserve Board to raise interest rates and contract the money supply. Unanticipated changes in the stability of prices create a period ofconfusion during which businesses reflect on new information and its impacton production and sales. 78). For instance,the consumer price index (CPI) is known for being overstated. 49). A14). 46) The fact that both prices and wages have remained at levels thatwould normally have triggered inflation in the past has led some economiststo conclude that fundamental changes have occurred in the economy. Consequently, Greenspan consults on ahost of economic indicators to gauge inflation including auto and trucksales, commodity prices, supplier performance, stock prices, factoryovertime, and reports on local business trends from the Federal Reserveregional banks. The Federal Reserve views inflation as the enemy of sustainableeconomic growth and price stability. If the FederalReserve could be certain that productivity is within normal limits, lowunemployment would not be so troublesome. said that it was becoming increasingly hard tomeasure inflation because rapid changes in the quality of goods andservices make it harder to define a unit of output and, hence a change inits price" ("Shoot," 1996, p. Central banking is a reactive process that involves continuous trialand error as well as constant observation and adjustment. 345). Since the funds rate represents the cost of day-to-day fundsfor banks and securities dealers, its movements foreshadow changes in theprime lending rate and other money market interest rates: "A central bankis a man-made institution that deliberately creates money by means of somekind of governmental prescription or license" (Timberlake, 1993, p. First, higher interest rates make bonds more attractiveinvestments than stocks. Economist (pp. Price stability minimizes corporateuncertainty and contributes to sustainable economic growth. 124). A1[2]).----------------------- 1 Greenspan,however, considered the stock market drop positive, and expressed hopesthat it would help slow the economy: "For nearly a year, he has beenpublicly questioning whether a speculative bubble was building in stocksthat would eventually burst" (Foust, 1997, p. . Chairman Greenspanwill continue to make adjustments in interest rates on a regular basis.Thus interest rates will function as key indicators of stock marketmovement in the new economy. This combination of rising prices and economicrecession became known as stagflation. (1993). News &World Report (pp. Wall Street Journal (p. This participation has ledto rising prices for assets, most notably the share prices of stocks andthe cost of real estate: "Far from being dead, inflation has taken on anew and more dangerous guise" ("On the Trail," 1997, p. In Karl Brunner and AllanMeltzer (Eds) Monetary Economics (pp. The availability of money and credit exerts a powerful influenceon business investment in new plant and equipment. References Brunner, K., Cukierman, and Meltzer, A. 123-154). Second, rising interest rates eventually weakeneconomic activity and depress the profits outlook. For example, when RichardNixon became president he inherited a five percent rate of inflation(considered unacceptably high in those days). The bull market of the 198 s was fueled by irrational consumerconfidence. The stock market is particularly sensitive to Federal Reserve policy.
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