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President's Message: It's A Small World, After All

By

William Poole

On Oct. 15, the Federal Reserve cut both the federal funds rate target and the discount rate by a quarter of a percentage point in response to concerns over domestic credit availability and unsettled conditions in U.S. financial markets, reflecting spill-overs from volatile economic conditions abroad. It was the first time since 1994 that the Fed cut the funds rate target between regularly scheduled Federal Open Market Committee meetings; it was the first time since 1996 that it cut the discount rate; and it was the second time in three weeks—after holding the federal funds rate target steady since March 1997—that it pushed interest rates down.

The fact that the Fed cut the fed funds target twice in 16 days reveals not only the severity of the financial troubles other areas of the world are experiencing, but also how interconnected our economy is to other countries through trade and investment. Foreign consumers and businesses buy products made in the United States, and American consumers and businesses buy products made outside the country. U.S. firms operate abroad, and foreign firms operate in the United States. Foreigners purchase U.S. stocks and bonds, while Americans own stocks and bonds issued by foreign firms and governments. U.S. banks make loans to foreigners, and U.S. companies borrow money from foreign banks. Because of this interconnectedness, when some of our trading partners are in recession the U.S. economy suffers many detrimental effects. Demand for exports wanes, earnings of some American companies operating abroad decline, and some foreign firms and governments have trouble paying back their debt—not to mention the blows U.S. investors suffer when foreign and domestic stock markets tumble.

Of course, the economic difficulties that other countries are experiencing have resulted in some benefits to the United States through commodity prices and interest rates. The price of commodities like oil, for example, has dropped in tandem with decreased demand by Asian and other countries. (The benefits of this effect are obvious to anyone who has filled a gas tank recently.) In addition, prices of Treasury securities have increased as investors attempt to reduce the riskiness of their portfolios.

Overall, however, the situation abroad is far more negative than positive for the U.S. economy. In the face of these negative effects, we must not forget the enormous, long-run benefits that flow to the United States from our active involvement in the world economy. It would be truly tragic for all of us if the United States—or any of our trading partners—were to turn inward because of the short-run shocks hitting us now.

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