We have seen the Federal Reserve take action to stimulate the economy by “lowering interest rates.” There is a lot of confusion out there about what this really means, so now seems like a great time to explain it.
The U.S. Federal Reserve (The Fed) has been injecting billions of dollars into the financial markets to maintain liquidity. Many people mistakenly think the Fed “sets” interest rates. That is partly true, but the open market has its say too. Let me explain.
The Fed sets both the Discount Rate and a target, or objective, for the Federal Funds Rate. However, while the Fed can ensure the Discount Rate does not fluctuate throughout the day, it cannot ensure the Federal Funds Rate wilI not fluctuate. The Fed has to walk a fine line in the open market to keep the Federal Funds Rate in line with its target rate.
The Discount Rate
is the interest rate at which banks in the Federal Reserve System can borrow money from the Fed at the discount window.
The Federal Funds Rate
is the rate banks charge each other as they lend their balances at the Federal Reserve to one another.
The more cash that banks have available to them, the more likely they are to lend. Banks don’t make money by sitting on cash. They make money by deploying that cash and charging interest. When the Fed injects huge amounts of cash into the banking system, banks begin lending that money. The natural result of this increased lending is a lower effective Federal Funds Rate because banks have to compete with each other when they are lending the money they have. If Bank A wants to lend more than Bank B, it has to lower its rates, which causes Bank B to lower its rates to keep up—and the cycle goes on until both banks reach the lowest rate at which they can still turn a profit.
A lower effective Federal Funds Rate means businesses can borrow money at a lower rate, merger and acquisition deals can find capital, and hedge funds can borrow money to leverage their accounts. The hope is that lower rates will help keep the economy growing, but only time will tell. We’ll have to keep an eye on the Fed to see what else it has up its sleeve.