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Central Banks Worldwide Cut Interest Rates Again

2001-11-12

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The Federal Reserve, the Bank of England, and the European Central Bank All Cut Interest Rates

At the start of 2000, all three central banks--the U.S. Federal Reserve, the European Central Bank, and the Bank of England--feared rising inflation, and were engaged in policies of raising interest rates to try to "cool off" their economies. The newly-founded European Central Bank wanted to establish its credibility as an inflation-fighter. The U.S. Federal Reserve was worried that the extraordinary stock market boom and the rush of investment into high-tech industries would trigger an upward inflationary spiral.

The Bank of England stopped raising rates in the spring of 2000. The Federal Reserve stopped raising rates in the summer of 2000. Only the European Central Bank continued to raise rates into the fall of 2000. Observers were puzzled: European unemployment was high, inflation was not rising, and a weakening world economy was bound to diminish European exports. Only the weakness of the currency, the euro, could account for the continued rise in interest rates. But the events of the 1970s and thereafter had, everyone thought, made central bankers aware of the dangers of trying to prop up the values of currencies by policies that intensified domestic unemployment.

The crash of the NASDAQ in the spring and summer of 2000 led the Federal Reserve to reconsider its position. Evidence of weakening investment led many observers in the fall of 2000 to call for interest rate cuts. In the winter of 2001 the Federal Reserve responded--four months late, according to many--but it responded rapidly and strongly, cutting interest rates 2.5 percentage points before the summer of 2001 began, and continuing cuts thereafter. The Bank of England and the ECB followed, more cautiously. The Federal Reserve's decisions to cut rates were the natural consequence of its decision to pursue aggressive monetary expansion to prevent recession. The ECB, by contrast, managed to, as the Economist put it, "give the impression that it begrudged each cut."

As the end of the summer neared, it appeared that a "soft landing" had once again been achieved. The interest rate cuts that the Federal Reserve had put in motion at the start of the year were about to begin to have their effects. Forecasters saw a strengthening U.S. economy beginning at the start of 2002. Britain was forecast to grow more rapidly than America. And the ECB was a question mark.

Then came the terror attack on the World Trade Center on September 11, 2001. The fall in consumer and investor confidence was remarkably large. Central banks cut interest rates in response--with the ECB once again lagging behind.

But will these interst rate cuts be enough to keep the current recession small? Can central banks cut interest rates by enough to maintain near-full employment? Nobody knows.


Previous Handouts

2001-11-05: Effects of the Collapse of Spending on Durables (Chapter 9: Income-Expenditure and the Multiplier)
2001-10-28: What Kind of Stimulus? (Chapter 13: Stabilization Policy. Chapter 9: Income-Expenditure and the Multiplier.)
2001-10-21: Federal Reserve Reaction to the Terror Attack on the World Trade Center (Chapter 13: Stabilization Policy. Chapter 10: The IS Curve.)
2001-10-14: Why a Stimulus Package Might Be Desireable (Chapter 13: Stabilization Policy. Chapter 10: The IS Curve.)


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