Why the Fed Keeps Cutting Rates

On October 29th, the Fed "slashed rates" again, reducing the key interest rate to a low 1%. Here's some information about what it all means.

What is the Fed?

The Fed is the Federal Reserve System, the central banking system in the US. Currently Ben Bernanke is the Chairman of the Board of Governors of the Fed. The Fed has a dual mandate: to promote stable inflation and maximum employment.

To do so, it controls the Federal Fund Rate. This is the interest rate at which banks lend money that they hold at the Federal Reserve to each other overnight. The Fed actually only sets a target rate, which is where they think the interest rate should be. They don't set the actual interest rate, because that is determined in the open market. The Fed just tries to lead everyone in the right direction.

Why do banks hold money at the Federal Reserve?

The Fed requires that each bank must have a minimum amount of reserves (money) deposited in the Fed. This minimum amount is a percent of the bank's total receipts from customers.

Why do banks lend to each other?

Some banks have excess reserve requirements and can help out those that have insufficient funds by loaning them money. At a price, of course. These loans are typically made for one day.

Why does the target rate matter?

It basically controls the supply of money. When the interest rates are low, banks have more access to credit (because they can now borrow from other banks at a lower interest rate) and are able to loan that money out to businesses and consumers. Businesses and consumers are more likely to borrow that money, because the interest they will have to pay on the loan will also be lower. As a result, people have more money on hand and, therefore, are likely to increase spending.

Since we may be in a recession and consumer spending has plummeted (the fastest decline in 28 years), the Fed wants to stimulate consumers to spend. Consumer spending represents about 70% of our GDP, or gross domestic product, which is the most widely used indicator of the health of the economy. Basically, the economy relies on consumer spending. So it is necessary to help consumers spend in order to keep the economy going. That means cutting interest rates.

The Federal Open Market Committee meets every month and announces the target rate. They started cutting rates last September—in August 2007, the target rate was 5.25%. Their announcement from the October meeting indicates more cuts may be necessary since "downside risks to growth remain." The last time the rate was lower, Eisenhower was in office (1958).

Read more of what Diana learned today here.