In the fourth quarter of 1998, the Federal Reserve cut short-term interest rates substantially out of fear that the economy was sliding into recession. The default of Russia on its foreign debt, the sharp rise in interest rate risk premia, and the spectacular bankruptcy of Long Term Capital Management led everyone to fear that businesses were about to cut back on their baseline investment spending.
If this were to happen--and if interest rates were to remain the same--the fall in investment spending would feed through into the multiplier process. It would reduce consumption spending as well. The fall in investment would trigger an amplified reduction in the equilibrium level of aggregate demand for each possible value of the interest rate.
Such a fall in aggregate demand would be a leftward shift in the position of the IS curve. Unless the government did something to boost investment and move the economy down and to the right along the IS curve, the result of this inward shift would be reduced production, increased unemployment, and an economy in recession.
Hence over the fall of 1998 the Federal Reserve decided to cut its target for the nominal short-term overnight federal funds annual interest rate by three-quarters of a percentage point. Even if baseline investment spending did fall, the reduction in the interest rate should offset or moderate the fall in production. The Federal Reserve's shift in policy was substantial. In combination with then-rising inflation, the short-term real safe annual interest rate fell from 4.5% in the first half of 1998 to 3.2% in the first half of 1999.
The Federal Reserve's shift in policy was successful. As baseline investment spending was slowed in early 1999 by the financial disturbances of late 1998, real GDP growth slowed to a rate of 2.4 percent per year in the first half of 1999. But then, as the effects of the interest rate increases at the end of 1998 made themselves felt in the economy, investment picked up and real GDP growth accelerated to 6.5 percent per year in the second half of 1999.
By the end of 1999 the Federal Reserve was no longer worried about falling investment, rising unemployment, and recession. Instead, it was worried about a stock market boom causing overexuberance, possible rises in business plans for baseline invstment spending, upward pressure on aggregate demand, and rises in capacity utilization and falls in unemployment to points at which rapidly accelerating inflation would become inescapable...