Interest Rates Economy

By: EconomyWatch Content   Date: 6 November 2009

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Federal funds rate is the interest rate that banks charge for overnight loans of federal funds. Federal funds are reserves held by various banks at the US Fed. Market forces determine this rate, and the Federal Reserve or the Fed does not mandate it. The Fed, however, aligns the effective federal funds rate with targeted rate through open market operations.

 

Interest Rates Economy – Discount Rate 

The Federal Reserve sets the discount rate directly. Discount rate is the interest rate for “window lending” overnight loans that banks borrow from the Fed directly. This rate is set 100 basis points above the target federal funds rate to encourage banks to look for alternative funding before using “discount rate.” The European Central Bank calls this as “Marginal Lending Facility.” 

Interest Rates Economy – A Stimulant

Interest rates are used to control economic activities. For instance, lower interest rates can stimulate economic activities by reducing the cost of borrowing. This makes borrowing easier for both individuals and businesses with higher money supply. On the other hand, higher interest rates can slow down the economy as the cost of borrowing increases. Usually, the Federal Reserve adjusts the rate by 0.25% or 0.5%. The Fed also uses open market operations to adjust long-term interest rates. However, the buying power of the Fed is lower than private institutions.

Interest Rates Economy - New Tools 

The Fed has created new tools, such as Term Auction Facility, Term Securities Lending Facility, Primary Dealer Credit Facility and quantitative easing to address the problems associated with sub-prime mortgage crisis. Quantitative policy is relatively recent when compared to other policies. According to this policy, the US government buys government debt with newly printed currency. This policy is aimed at addressing the deflationary forces. 

 

The US Fed’s interest rate is one of the most effective tools in stimulating the economy and in dealing with inflationary pressures. The US government controls interest rate sensitive industries, such as mortgages, to control the whole economy. As of November 2009, the Fed is keeping the rates at historical low levels to address the recessionary trend.

 


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