The current Federal Reserve interest rate is between zero and .25%. It was lowered by 1/2 point on December 17, 2008, the 10th rate cut in a little over a year. Previous cuts include:
- Sep 18 07: A 1/2 point cut to 4.75%.
- Oct 31 07: A 1/4 point cut to 4.5%.
- Dec 11 07: A 1/4 point cut to 4.25%.
- Jan 22 08: A 3/4 point cut to 3.5%.
- Jan 30 08: A 1/2 point cut to 3%.
- Mar 18 08: A 3/4 point cut to 2.25%.
- Apr 30 08: A 1/4 point cut to 2%.
- Oct 8 08: A 1/2 point cut to 1.5%.
- Oct 29 08: A 1/2 point cut to 1%.
This primer explains why the Fed's aggressive expansionary monetary policy was needed to address the 2008 financial crisis.(Updated January 15, 2012)
1. How the Fed Funds Rate Works
Each month the Federal Reserve, through its Federal Open Market Committee (FOMC), targets a specific level for the Fed funds rate. This rate directly influences other short-term interest rates, such as deposits, bank loans, credit card interest rates, and adjustable-rate mortgages. By lowering the Fed funds rate so dramatically, the Fed kept funds available. It signaled financial markets that it would act decisively to keep them functioning.
2. How Exactly Does the Fed "Cut" the Fed Funds Rate?
The FOMC sets a target for the Fed funds rate at its monthly meeting. This Federal interest rate is charged for Fed funds, which are loans made by banks to each other to meet the Fed reserve requirement. Technically, these rates are set by the banks themselves, not the Federal Reserve. Find out why, for the most part, these rates rarely vary from the target rate.
3. Historical LIBOR Rates
After the Fed bailed out Bear Stearns, it thought the crisis was over. In April 2008, the LIBOR rate started to diverge from the Fed funds rate. The Fed lowered the Fed funds rate, but LIBOR continued to rise. Despite the Fed's reassurance, banks continued to panic, and were unwilling to lend to each other. They were afraid of receiving subprime mortgages as collateral. By October 2008, the Fed funds rate was 1.5%, but LIBOR was 4.3%. This was the financial crisis of 2008.
4. How the Fed Intervened Throughout the Credit Crisis
In August 2007, banks became fearful of loaning each other funds, causing the LIBOR rate to rise. The Fed initially tried to calm this panic by adding funds to the discount window, hoping that this would restore liquidity and confidence in financial markets. When that didn't work, the Fed realized it needed to lower the Fed funds rate. By 2008, the Fed bailed out Bear Stearns, bought AIG, and made nearly unlimited funds available to banks to prevent global financial market collapse.
5. Fed Exit Plan Puts to Rest Inflation Fears
Many people are worried that the Fed's stimulus programs created another inflationary bubble. That just won't happen. Federal Reserve Chairman Ben Bernanke wound down most of the programs that steered the worlds' largest economy away from collapse. He also outlined a plan to absorb money the Fed has pumped into banks since August 2007.
6. A Primer on the Subprime Mortgage Crisis
The first clue to the recession to come was in the housing market, when subprime mortgages started to default. During the real estate boom, mortgages were made to subprime borrowers with poor credit history. These mortgages were hidden in packages resold by banks in the secondary market. Hedge funds, banks, and other investors bought them, thinking they were solid investments because credit rating agencies like Standard & Poor's said so. When borrowers defaulted, financial firms like Lehman Brothers went bankrupt. This caused a panic, since no one really knew how big the problem was....or still is, for that matter.
7. Fed's Operation Twist Won't Help Housing
"Operation Twist" is a $400 billion program that is supposed to boost the housing market and economic growth. But will it? The Fed bought billions of mortgage-backed securities from banks. When these mature, the Fed will buy more. That's good. But the second part of Operation Twist -- the "Twist" -- is designed to keep long-term interest rates low. The Fed will sell off the short-term Treasury bills it holds and use the proceeds to buy long-term Treasury notes and bonds. Unfortunately, it doesn't address the real problem with housing -- massive foreclosures in the pipeline. The Fed can't create demand, and no one wants to buy a house if they know it won't increase in value. The Fed's Operation Twist is like pushing a string.
8. How Interest Rates Affect the Economy
The Fed funds rate is probably the most significant economic indicator in the world. Its importance is psychological as well as financial. In fact, it really only directly impacts the prime lending rate and adjustable rate mortgages. The 10-year Treasury note sets longer-term conventional mortgage rates. Find out how the two interplay in controlling recession and inflation.
9. Inflation Frequently Asked Questions
Bernanke has said that the primary role of the Fed is to control the public's expectation of inflation. This means that, in a healthy economy, he'd rather have higher interest rates to stifle inflation. It makes his willingness to lower the Fed funds rate so decisively all the more dramatic. Learn how inflation affects you and how the Fed uses the Fed funds rate to manage it.
10. Exchange Rates Frequently Asked Questions
By lowering the Fed funds rate, the Federal Reserve decreases the value of the dollar vis-a-vis other currencies. Find out how this works in this series of Frequently Asked Questions about exchange rates.
