| Know your Fed: A description of
the Federal Reserve |
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Those lacking reserves can borrow money to meet reserve requirements either directly from the Fed or from each other. When banks borrow from the Fed, they pay interest at the discount rate. That doesn't happen very often, though, because discount rate borrowing is supposed to be used as somewhat of a last resort. For that reason, the discount rate isn't all that important.
But financial institutions borrow from each other all the time. When they do so, the borrowing bank pays interest to the lending bank at the federal funds rate. Banks are more than willing to lend out their excess reserves, too, because they don't earn any interest on the money they have to keep deposited with the Fed.
Keeping the rates on target
The actual funds rate fluctuates all the time depending on market conditions. But the Federal Reserve Bank of New York can keep the rate near the target spelled out by policymakers at the last FOMC meeting by trading securities with private-market institutions. If the Fed wants to drive the funds rate lower, it increases the supply of available reserves in the marketplace by buying securities.
When that happens, banks can obtain money to lend out more cheaply. They pass at least some of the lower cost of operating through to their customers. Whenever the funds rate falls, for instance, banks lower their prime rates. That, in turn, lowers the rates on products whose rates are tied to prime, including home equity lines of credit and credit cards. Banks also lower their rates on certificates of deposit, car loans, personal loans and the like.
So what impact does that have? The lower cost of financing a new car prompts consumers like you to go out and replace their hulking, $60-a-fillup SUVs with shiny new subcompacts. Dealerships start running out of cars and order more from their factories. Managers who fired workers months ago when demand slowed suddenly find they can't keep the assembly lines running. They start placing "Help Wanted" ads on the Web and hire more workers, who suddenly find themselves with money to spend, too.
Meanwhile, investors who got wind of the improved car sales outlook start buying the stock of XYZ Motors and all of its suppliers. That makes the monthly mutual fund statements of Americans everywhere look better than they have in a long time, boosting consumer confidence and wealth. The cycle continues, the economy improves and FOMC members bask in the warm glow that comes from knowing they saved us all from destruction.
So there you have it. While predicting whether and by how much Fed policymakers will cut rates is a difficult task, at least now you know how they do it!
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