Fed Funds? Discount Rate? Huh?

If you have looked at the news today, then you already know that the Federal Reserve announced that it is cutting the Federal Funds Rate from 4.25% to 3.5% and the Discount Rate (window) from 4.75% to 4%. As a matter of fact, you can’t visit yahoo.com, msn.com, cnn.com, or any major news TV station without seeing it, which made me wonder… how many people have the slightest idea what this means?

I’ve got to admit… until last year I had no idea what all of this government mumbo-jumbo meant either. Discount rates? Isn’t that what you get at Wal-Mart or Marc’s? Discount window? Isn’t that what that asshole on the info-mercial keeps trying to sell me at 2:30am?

This post is for anyone who is unsure of what the hell all of these terms mean. I by no means intend to cover all of the implications of this crap, but hopefully this will be insightful enough to make at least a little bit of sense.

The Federal Funds rate is simply the rate at which banks borrow money (funds) from other banks. In order to protect depositors (you and me) from banks lending all of our checking accounts and savings accounts out to other people (and hence us bouncing our checks), the Federal Reserve (the head-honcho bank) requires that banks keep a minimum amount of reserve funds at the Federal Reserve (currently 10%). So here is the deal:

If the bank wants to make a loan but doesn’t have enough reserves without going below their reserve requirement, they can borrow money from another bank with excess reserves at the Federal Reserve (the Fed from here on out). The rate that they will pay for the loan is called the Federal Funds Rate. Basically, the lower the Fed Funds Rate, the easier (cheaper) it is for banks to borrow money from each other to make loans, meet reserve requirements, etc… This has the effect of basically adding additional money to the economy (increases the money supply).

The other rate that was lowered was the discount rate or ‘discount window’. This is the rate at which banks can borrow not from other banks but directly from the Federal Reserve. It is usually about a percentage point higher than the Fed Funds Rate (naturally, the Fed doesn’t want to lend its money to banks, so it is cheaper for banks to borrow from each other).

You will hear these rates referred to as monetary targets for open market operations. Open market operations are simply the means by which the Fed controls the supply of money in the economy.

Note:

When these two key interest rates are low, it often signals ‘easy money’, and can lead to inflation. When inflation is high, the Fed usually raises these two key interest rates in an effort to ‘cool’ the overheating economy. When economic growth is low (like what we are seeing in the economy presently), the Fed will lower interest rates in an effort to make funds easier to obtain, hence stimulating a slow economy.

Here is the catch… what do you do if the economy is slow and inflation is high?

Think about it…

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