Business and economic information you need to know
Oct 8, 2008 1:24 pm US/Eastern
How An Interest Rate Cut/Hike Works
WASHINGTON (CBS4.com) ―
-
-
NYSE signs top trading posts on the floor of the New York Stock Exchange in New York.
AP
Wednesday's action by the Federal Reserve to cut the key interest rate was meant to be the catalyst to help free up the almost frozen credit markets. The question is then, what does the Fed's action mean to the American consumer?
The Federal Reserve's primary role is to set monetary policy for the United States. It does this in a number of ways, including through interest rates.
The federal funds rate is the rate that banks charge each other for overnight loans. The Fed works through the Federal Open Market Committee, or
FOMC, tries to set a specific level for the federal funds rate.
The rate the Fed targets influences not only overnight loans, but also things such as deposits, bank loans, credit card interest rates, and adjustable-rate mortgages.
Theoretically, if the rate is higher, banks are not willing to loan out much of their money without charging a higher interest rate. This means loans for everything from cars to help for small businesses to meet payroll will have a high interest rate for the consumer.
On the other side, if the rate is lower, banks should be willing to open up the credit market more and charge less interest on many loans. But, the danger of lowering rates too far is inflation begins to rise and the value of a dollar around the world may drop.
This is where the Fed's main job comes in. The Fed must try to maintain and sometimes spur on economic growth, but also control inflation. It uses both rate cuts and hikes to meet these goals.
The stock market watches the FOMC meetings and decisions very closely, hoping for any type of rate cut that might help economic growth. They also watch to see if there is too much growth, inflation starts to rise.
Think of it this way, a bank gives a loan to a small business that then uses the money to buy up products made by other businesses. These businesses continue the chain by buying up other businesses products and consumers buy up products all through the chain. The banks then make interest on the loans and then loan out more money and the cycle begins again.
But, the problem with rate cuts or hikes is that it can take months to get down to the customer. Most economists say it can take up to a year for the rate changes to make their full impact. That means while the market may enjoy a quick rise and stockholders may see a quick profit, customers of banks will have to be patient waiting for the rate cut to get to them.
(© MMIX, CBS Broadcasting Inc. All Rights Reserved.)
Business/Economy
Click to enlarge
One Dead In Head On Crash Near Land Shark Stadium 3 mins ago
Stumble It!
