A Primer on Current Federal Reserve Interest RatesOn April 30, the Federal Reserve's Open Market Committee (FOMC) cut the Fed Funds rate 1/4 point to 2.00%. This followed a dramatic 3/4 point cut to 2.25% on March 18, a 1/2 point to 3% on January 30, 2008, an aggressive 3/4 point cut a week earlier, and a 1/4 point cuts on December 11, 2007 and October 31. That makes seven total rate cuts in seven months, including September 18 when the Fed dropped rates 1/2 point, the first rate cut in four years.
This primer will explain why the Fed's aggressive expansionary monetary policy, how it will affect the U.S. economy, and what it means for you. Each month the Fed, through its Federal Open Market Committee (FOMC), targets a specific level for the federal 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 hopes to jump-start the economy in one swift and decisive move by reinstilling confidence lost during the recent 2007 Banking Liquidty Crisis. In August 2007, banks became fearful of loaning each other funds, causing the overnight 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 it did not work, the Fed realized it may need to lower the Fed Funds rate.
Find out what else the Fed has done to resolve the banking liquidity crisis. The 2007 Banking Liquidity Crisis was caused by the Subprime Mortgage Mess. During the real estate boom of the past few years, mortgages were made to subprime borrowers, who had poor credit history. These mortgages were resold in the secondary market to hedge funds, other banks, and other investors. When these borrowers defaulted, hedge funds and banks started to go bankrupt. This caused a panic, since no one really knew how big the problem was....or still is. The Fed Funds rate is probably the most significant economic indicator in the world. It's 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 bond has more of an impact on 15- and 30-year conventional mortgages rates. Find out how the two interplay in controlling recession and inflation. Federal Reserve Chairman Ben Bernanke has said that the primary role of the Fed is to control the public's expectation of inflation. This means that his predisposition is towards higher interest rates, and makes his willingness to lower the Fed Funds rate as he did in September all the more dramatic. This series of FAQ's explains inflation, how it affects you and how the Fed used the Fed Funds rate to manage it. By lowering the Fed Funds rate, the Federal Reserve has also decreased the value of the dollar vis-a-vis other currencies. However, the impact will be muted by the stability of the the Treasury Bond interest rate. Find out more about how this works in this series of Frequently Asked Questions about exchange rates. An immediate reaction to the lowering of the Federal interest rate was banks' lowering of the prime interest rate. This will increase liquidity to the banks' best customers, and hopefully counteract the affect of defaults with subprime mortgages. The risk that still remains is that no one knows how far the Subprime Mortgage Mess has spread. For example, Mortgages are one type of Asset-backed debt. It appears that subprime loans were made for all kinds of Asset-backed loans, including auto loans and even corporate debt. The extent of defaults in Asset-backed Commercial Paper is yet unknown...and one reason why the Fed took such a dramatic step in its September FOMC meeting.
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