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The Honolulu Advertiser
Posted on: Wednesday, March 21, 2001

Fed created slowdown to stem 'irrational exuberance'

 •  Rate cuts by Fed 'not instantaneous'

Associated Press

Q.: I've watched while the Federal Reserve raised interest rates to create a slowdown. Now it's lowering rates again. Why did we need a slowdown in the first place?

A.: The reasons involved will probably always be controversial and subject to criticism because they involve somewhat subjective decisions. But this is the traditional explanation:

An economy is said to be overheating when demand runs up against the capacity to produce. That capacity is measured by, among other things, the amount of raw materials available, the country's unused plants and equipment, available labor supply and the money supply.

When these are strained, production can't rise but production costs can.

All this is a formula for inflation, which is probably the No. 1 concern of the Federal Reserve, whose duty it is to watch over monetary affairs, such as interest rates, with the goal of keeping an economy in equilibrium between supply and demand.

The stock market is an important part of the economy, but it isn't the entire economy. Still, its effects can spill over, so the Fed always must keep an eye on the interaction between them.

Beginning in the late 1990s, Federal Reserve chairman Alan Greenspan became concerned about what he called "irrational exuberance" in the stock market.

Stock prices were being bid up to unusually high levels, creating a sense of financial well-being that added to demands on the economy. Determined to re-establish equilibrium, the Fed stepped in with six interest rate increases in a 15-month period in 1999 and 2000 to slow the expansion to what it considered a sustainable level.

The impact of these increases struck the economy hard as 2000 wore on. In fact, by January 2001, the Fed felt compelled to let up, and an effort began to bring down interest rates once again in an effort to achieve that desired supply-demand balance.

What makes sharp interest-rate increases especially controversial is that a slowdown hurts people. Corporate earnings fall, jobs are lost and ambitions are crushed. And there is also the risk of recession.