Interest Rates Essay

The interest rates need to be increased only when the economy is believed to be growing extremely well and thus possibly overheating. Increased interest rates imply higher costs of borrowing for banks and businesses and in theory is meant to discourage borrowings for business purposes and thus somewhat slowing economic activity.

One needs to remember that the interest rates indeed make sense in situations when they have reached a certain level and make material difference to the businesses.

Furthermore, one cannot indefinitely lower the interest rates since they cannot go below 0%. So, when the interest rates fall to about 1.0-1.5% the Fed becomes incapable of solving problems in the US economy by manipulating the interest rates. The current fed funds rates are 3.5% which gives the Fed a relatively large leeway for maneuvering. From 2002 to 2004, the interest rates would vary around 1%-2%, so the current 3.5% rates are rather high. The rates in the 1990s would fluctuate around 4-5%. Thus, one can see the reasoning why the Fed strives to raise the interest rates (Cochrane, 2004).

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Taking into account the current disasters that take place in the USA, and the shaky US economy suffering from raising oil prices, one can say that the interest rates should not be raised yet rather lowered.

The pace would depend on the direction of the interest rates and the current interest rates. Furthermore, the rates need to be changed in a way to influence the economy. If one changes the rates by 0.000001%, the market would not notice the rate change at all. Typically the Fed changes the rate by a quarter of a percent (0.25%). As the interest rates fall and approach zero, the Fed has no choice but to lower it by small fractions of a percent (Grupe, 2004).

I believe that the rates would raise to about 5%, since as far as I remember it was Allan Greenspan who considered this rate to be ideal for normally functioning economy. So if the US economy improves over the next 12 months, the interest rates would increase to reach 5% (Jones, 2004). Once again, if Allan Greenspan resigns one would expect the interest rates to change according to the expectations of the new Chairmen of the Fed. The increments at which the interest rates will increase will depend on the pace of the increase of the US economy. If it dramatically improves one would expect the rates to raise by some 0.5%. if the growth of the US economy is moderate one would expect the rates to grow by increments of 0.25%.

If the Federal Reserve is going to adjust all of these tools during an economy that is growing too quickly, it will be able to set the tempo for the economic growth. The economy that grows too quickly faces the risk of being overheated, so the Federal Reserve should adjust its policies to assure that the interest rates in the economy are located at a certain level, just like the other essential indicators change according to the norms that the Federal Reserve finds appropriate for this economy. The Federal Reserve will engage in the contractionary policy by which the Federal Reserve will lower the money supply by selling government securities, increasing the reserve requirements, and increase the interest rates. By the same token, whenever the economy is slow/economic recession, the bank will engage in the expansionary monetary policy in which the money supply will be lowered by buying government securities, lowering the reserve requirements and lowering the interest rates (Alesina, 2004).

At present the US economy as based on various indicators seems to be below the levels of 1990s and thus probably needs some potent boost that would be represented by the expansionary monetary policy initiated by the Federal Reserve. As it would be in any other case, the Federal Reserve should lower the interest rates, lower the reserve requirements, and purchase some government securities.

Bibliography:

Federal Reserve bank, http://www.federalreserve.gov/releases/h15/data/m/fedfund.txt, Accessed September 15, 2005.
Cochrane, John, 2004, The Fed and interest rates: A high-frequency identification (NBER working paper series), Prentice hall, pp. 90.
Grupe, Arthur, 2004, Fed Official: Interest Rate Moves May Work. (Robert T. Parry, President of Federal Reserve Bank of San Francisco), San Diego Journal, p. 120-122.
Jones, David, 2004, Fed Watching and Interest Rate Projections: A Practical Guide, NY Random House, pp. 204-205.
Alesina, Alberto, 2004, Political Cycles and the Macroeconomy, Barrons books, pp. 143-149.

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