 Ask
Dr. Econ
January 2002
Why did the Federal Reserve System lower the federal funds and discount
rates below 2 percent in 2001?
Federal Reserve Board Chairman Alan Greenspan's recent testimony before
Congress and the Fed's Monetary Policy Report submitted to Congress on
February 27, 2002, carefully describe the deterioration in the economy
in 2001. Both also highlight the Fed's monetary policy efforts to counteract
the slowing economy by lowering interest rates in the federal funds market-overnight
loans between banks-and
at the discount window-overnight loans made by Federal Reserve Banks to
depository institutions.
In the paragraphs below I've included excerpts from the Monetary Policy
Report that comment on the economic situation in 2001 and the Fed's policy
responses. For additional detail, I'd recommend reviewing the February
2002 Monetary Policy Report online at the Federal
Reserve Board's website.
The slowdown in the growth of economic activity that had become apparent
in late 2000 intensified in the first half of the year (2001). Businesses
slashed investment spending--making especially deep cuts in outlays
for high-technology equipment--in response to weakening final demand,
an oversupply of some types of capital, and declining profits. As actual
and prospective sales deteriorated, many firms in the factory sector
struggled with uncomfortably high levels of inventories, and the accompanying
declines in manufacturing output steepened. At the same time, foreign
economies also slowed, further reducing the demand for U.S. production.
The aggressive actions by the Federal Reserve to ease the stance of
monetary policy in the first half of the year provided support to consumer
spending and the housing sector. Nevertheless, the weakening in activity
became more widespread through the summer, job losses mounted further,
and the unemployment rate moved higher. With few indications that economic
conditions were about to improve, with underlying inflation moderate
and edging lower, and with inflation expectations well contained, the
Federal Reserve continued its efforts to counter the ongoing weakness
by cutting the federal funds rate, bringing the cumulative reduction
in that rate to 3 percentage points by August.
The devastating events of September 11 further set back an already
fragile economy. Heightened uncertainty and badly shaken confidence
caused a widespread pullback from economic activity and from risk-taking
in financial markets, where equity prices fell sharply for several weeks
and credit risk spreads widened appreciably. The most pressing concern
of the Federal Reserve in the first few days following the attacks was
to help shore up the infrastructure of financial markets and to provide
massive quantities of liquidity to limit potential disruptions to the
functioning of those markets. The economic fallout of the events of
September 11 led the Federal Open Market Committee (FOMC) to cut the
target federal funds rate after a conference call early the following
week and again at each meeting through the end of the year.
The chart shows the impact of the FOMC's 2001 monetary policy decisions
on the federal funds and discount rates. It indicates the progressive
declines in both rates during 2001 as the Fed sought to use monetary policy
to stimulate the weak economy. As a result of those 2001 decisions, both
rates are low by historic standards. In January 2002, the Federal Reserve's
federal funds rate target of 1.75 percent resulted in the lowest average
federal funds market interest rates since 1961. The January 2002 discount
rate of 1.25 percent was the lowest since 1948.
Endnotes
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