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Chapter 13. An Orange Squeezed > The Economy Changes

The Economy Changes

The interest rate figure also illustrates how the Federal Reserve continually lowered interest rates in the early 1990s to stimulate the economy. However, at the beginning of 1994, the Fed began to feel that the economy was starting to overheat and that inflation might become a problem. It changed its focus from one of stimulating the economy to one of fighting inflation. To choke off inflation, the Fed increased short-term interest rates from 3.00% to 3.25%. This was just the first of six interest rate increases in 1994 that left the short-term rate at 5.5%.

This change in monetary policy caught many bond investors by surprise. An increase in interest rates causes the value of existing bonds to fall. The significant gains bond investors enjoyed when interest rates were falling could turn into losses if rates increased too much. Those investors with leveraged bond portfolios would face magnified losses. Indeed, there were several warnings to Robert Citron and the county supervisors that the portfolio was risky, and the wisdom of the investment strategy was questioned. These warnings were ignored by the supervisors and met with belligerent posturing by Citron.


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