Federal Rate Cut And How It Affects Us

Today marks the second day after the Fed decides to cut the rate by half a point. And today, also marks the day after many weeks that my 401k gets out of the red. I know you are not supposed to have emotional swing with the market because if you do, you will lose many nights’ sleep and have numerous heart attakcs, but nonetheless, this is a bit exciting. Moving on.

In the news and especially lately, we hear people talking about the Fed. We also hear people talking about “the rate”. But what exactly are they?

The Fed
Fed stands for the Federal Reserve System that is the central banking system of the United States that has members ranging from goverment officials, regional banks, some private banks, economists and what have you. Slightly irrelevant. The important thins is that the current chairman of the Fed is Ben Bernanke and with the famous Alan Greenspan as the predecessor, so pay attention to them in the news if you care about the financial market.

“The Rate”
“The rate” stands for the federal funds rate, which is the interest rate banks charge each other. Banks are required to keep certain level of federal funds at the Federal Reserve. They want to keep their federal funds as small as possible because money in federal funds is just sitting there and does not make them MORE money. A bank with an excessive level of funds will charge another bank with a deficient level of fund to borrow money at “the rate”. Also, when the rate is low, banks can borrow more money to generate more business at a lower cost. You see how much the banks are affected by the rate. This is why the stock market is affected when the rate changes.

Now, how does that relate to us?
Because the federal funds rate affects the cost of the banks, it makes the interest rate on loans offered to consumers goes up or down (i.e. auto loan, credit cards…). This means the cost of the banks got partly transferred to us consumers, so the rate also affects the spending power of consumers. When consumers can spend more, all business will do well. When they can’t spend as much, business will grow slower or stop growing. This is another reason why the rate affects the stock market.

In short, rate increase leads to higher cost for business (bad news).
Rate decrease helps in stimulating business growth (good news).

These are my basic understanding of the fed and the rate and quickly explained.
As you can read, it is quite straight-forward.

However, there are many other factors and market conditions also involved. For example, too much growth will cause inflation to go up dramatically, which is bad for the long term. In that case, the rate will be increased to curb growth to allow sustainability of the economy. Additionally, as far as now is concerned, the rate cut may lead the people who made the mistakes that lead to the current credit/subprime crisis to overlook their flaws. Then history will repeat itself, with a worse occurrence possibly…

Hear what Greenspan explains some of this on Daily Show!

I enjoy how Jon Stewart rasied the critical questions with Greenspan about how the economy favors investing in the market , hedge funds, short bettings over work and simple savings and also the illusion of a free market.

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