Rate Adjustments by the Federal

¶ … Rate Adjustments by the Federal Reserve Bank Conventional, classical economic wisdom suggests that the central bank of the United States, the Federal Reserve Bank, should raise the rate of interest to cool down a potentially overheated economy that may spiral into inflation, and lower the rate of interest to encourage spending amongst thrifty consumers who are holding onto their pennies when recession looms upon the horizon during an economic slow-down.

This is because "lower interest rates make it easier for people to borrow in order to buy cars and homes," as these are items that most consumers do not purchase with ready cash, but do so by borrowing money at the current rate of interest from a bank. Borrowing these so-called big-ticket items has a positive effect upon the rest of the economy. "Purchases of homes, in turn, increase the demand for other items, such as furniture and appliances, thus providing an additional boost to the economy.

Lower interest rates mean that consumers spend less on interest costs, leaving them with more of their income to spend on goods and services. Lower interest rates make it easier for farmers, manufacturers, and other businesses to borrow to invest in equipment, inventories, and buildings" ("Interest rates and the economy," Federal Reserve Bank of New York, 2007). However, the economy does not always behave classically, according to textbook wisdom.

For example, after the Great Stock Market Crash of 1929, people hoarded money and refused to spend, regardless of the interest rate, because they were not sure if they would lose their jobs. This caused the economy to contract further. During the 1970s, high inflation and sluggish growth were paired together, although it was usually assumed that the dangers of recession and the dangers of inflation were mutually exclusive entities. Furthermore: "Interest rates do not seem to affect the amount that people save.

That's because higher interest rates have two conflicting effects on how much people save. First, the higher return that savings can earn gives people an incentive to save more. Second, however, the higher return makes savers feel richer, so they may spend more, rather than save more ("Interest rates and the economy," Federal Reserve Bank of New York, 2007).

In other words, there are always pros and cons to every decision the Fed makes regarding the rate of interest, and while Fed policy can help consumers and the economy, it can also negatively impact many individuals' futures, such as people who need to borrow money or have borrowed money at a variable rate of interest. Setting the rate of interest and predicting consumer behavior patterns can be as much art and psychology as economic science for the Fed, by its own admission.

After the terrorist attacks of 9/11 and the ensuing recession, the Fed slashed rates, creating an interest rate bonanza for consumers who wished to buy a new car or a house. The recession was partially due to the real, economic effects of the destruction that had ensued after 9/11, but the recession was also partially caused by people's fears. To counteract these fears, the Fed thus lowered rates.

Then, fears of inflation in 2004 caused the Fed to raise interest rates at a steady rate, making it more difficult for consumers to borrow money, and giving consumers that had already borrowed money, such as people living off of a Home Equity line of credit or with adjustable rate mortgages, especially hard-hit by the frequent rate hikes (Willis, 2006).

Even after Hurricane Katrina, the Fed still continued to raise rates, from 3.5 to 3.75%, fearing a spike in the rise of energy costs, and confident that the potential for recession was merely a momentary blip, which occurs after any natural disaster ("Fed lifts interest rate to 3.75%" BBC News: Business. 2005). The current Fed Chairman, Ben Bernanke, noted that despite the increase in energy prices, the U.S.

economy, because of Fed policy, had not endured the spiraling inflation of the 1970s, although many consumers protested that such a high interest rate was prohibitive, especially to consumers living in the areas of the U.S. who were attempting to rebuild their lives after the catastrophic hurricane. But when the Fed declared a moratorium on its consistent hikes in 2006, not everyone cheered.

Said one economist: "According to their statement, the main reason is that the Fed believes inflation is destined to fall even in the absence of further monetary tightening. I find both good news and bad news in that rationale. The good news is that the Fed is looking ahead, acting on a forecast, rather than just opening the window, taking the economy's temperature and deciding what to do. The bad news is that inflation forecasts are not very accurate.

And the other bad news is that if the Fed expects a weak economy to drag inflation down appreciably, it must be pessimistic about the outlook for growth" ("Commentary: The pros & cons of unchanged interest rates," Nightly Business Report. PBS.com, 2006).

Little had really changed in the economy, said some economists, the Fed was either bowing to public or political pressure not to raise the rates, although inflation was still a potential threat and indications of economic change were mixed ("Commentary: The pros & cons of unchanged interest rates," Nightly Business Report. PBS.com, 2006). Today, the Fed has held the key interest rate steady at 5.25% for "just over a year" and seems unlikely to raise rats in the future ("Public affects inflation," AP Wire, 2007).

But although it has defended its recent policy, the Fed admits that its decisions are never a science, and it weights the potential accuracy of forecasts in light of consumer psychology. The current chairman Ben Bernanke said this means that the Fed cannot ignore the threat of inflation anymore than it can ignore indebted consumers who are worried about the effect of high interest rates upon their monthly budget.

"If investors, consumers and businesses feel confident that the Fed will keep prices stable...they may be less inclined to act in ways that could aggravate inflation," because "these groups may be less inclined in such circumstances to worry that inflation will eat away at investments and paychecks, and might feel better about longer-term financial planning" ("Public affects inflation," AP Wire, 2007). In short, consumers living off of their assets, like retirees, may be more willing to spend more freely if they feel those assets are not in jeopardy.

Still, Chairman Ben Bernanke's remarks "touched on the challenges of measuring so-called inflation expectations of the public and investors" ("Public affects inflation," AP Wire, 2007).