Tuesday, January 29, 2008

Why bothers about Federal Fund Rate?

The US stock market would have plunged into the deep end if not a timely 75 basis points Fed Rate cut by the Federal Reserve Open Market Committee (FOMC) last week. What is this Fed Rate actually all about? Why are everyone so particular with this rate? I like to shed some light for you.

The Federal funds rate is the rate that banks charge each other for overnight loans. It is a target rate and not the actual rate because the actual rate is determined by the open market. The key question to understand about this rate is “Why would one bank needs to borrow cash from another"

Example: When a bank needs to raise funds quickly to finance a major industry project, they have no time to wait for deposits from the public or interest from their loans to come it, they have to borrow from other banks which the interest is normally the Federal Rerseve rate.

When the Federal Fund Rate is low, the banks will freely lend to each other. This can spur economic development because it is natural that the lower the interest rate, the higher the demand it will be, for businesses to borrow money.

If the rate is kept too low, it will result in "too much money chasing too few goods". Too few goods often create Inflation. If the rate is kept too high, it will result in Deflation and possibly recession.

The other rate used by the Federal Reserve is called the "Discount Rate". I'll share with you in my next posting.

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