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How Does the Fed Lower Interest Rates?

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Federal Reserve Chair Janet Yellen carefully considers the economic indicators before changing the Fed funds rate.

Photo: Alex Wong/Getty Images Fed chairs

(L-R) Federal Reserve Chairs Janet Yellen, Paul Volker, Alan Greenspan and Ben Bernanke used the Fed funds rates to varying degrees.

Photo: Alex Wong/Getty Images

Question: How Does the Fed Lower Interest Rates?

Answer: The Federal Reserve cuts the Federal funds rate through its regularly scheduled Federal Open Market Committee (FOMC). The FOMC sets a target for the Fed funds rate after reviewing current economic data. This interest rate is charged by banks who lend Fed funds to each other. All banks must meet the Federal reserve requirements each night. If they don't have enough reserves, they will borrow the Fed funds needed to do so.

Technically, the Fed funds rate is set by the banks themselves, not the Federal Reserve. However, the Fed can use its open market operations to put pressure on the banks to raise and lower the rate. The Fed simply purchases assets from the banks (usually Treasury notes) and places a credit on the bank's reserve account. Now the bank has reserves it doesn't need to meet its requirement. Therefore, it's willing to lower its Fed funds rate to lend the extra reserves to other banks. For the most part, the Fed funds rate rarely varies from the target rate.

However, the Fed has other tools it uses to reinforce the Fed funds rate. It can change the discount rate, which is what it charges banks who borrow directly from its discount window. These are some of the tools the Fed used to restore liquidity in the 2007 Banking Crisis.

The Fed funds rate is used by banks to set their other short-term interest rates. They charge a bit more for LIBOR, which is what they charge each other for one-month, three-month, six-month and one-year loans. It's also a base for the prime rate they charge their best customers. Banks use the Fed funds rate as a base to determine the interest rates they pay on NOW checking accounts, CDs and savings accounts. It also guides the higher interest rates they charge for bank loans, credit cards, and adjustable-rate mortgages. Article updated February 21, 2014

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