Understanding the Discount Rate vs. the Federal Funds Rate
By S. Wade Hansen, 13 August 2007
The U.S. Federal Reserve (The Fed) has been injecting billions of dollars into the financial markets to maintain liquidity amid rising interest rates. But how could interest rates be rising? Doesn't the Fed set interest rates? The answer is "Yes," but the open market has its say too. Let me explain.
The Fed sets both the Discount Rate and a target, or objective, for the Federal Funds Rate. However, while the Fed can ensure the Discount Rate does not fluctuate throughout the day, it cannot ensure the Federal Funds Rate wilI not fluctuate. The Fed has to walk a fine line in the open market to keep the Federal Funds Rate in line with its target rate.
The Discount Rate is the interest rate at which banks in the Federal Reserve System can borrow money from the Fed at the discount window.
The Federal Funds Rate is the rate banks charge each other as they lend their balances at the Federal Reserve to one another.
The liquidity crunch that people have been talking about has been caused by a rising effective Federal Funds Rates, not by a rising Discount Rate. This means that banks are charging each other more than the target Federal Funds Rate of 5.25 percent to borrow on each bank's reserves, respectively. To combat this problem, the Fed has been injecting money into the markets.
The more cash that banks have available to them, the more likely they are to lend. Banks don't make money by sitting on cash. They make money by deploying that cash and charging interest. When the Fed injects huge amounts of cash into the banking system, banks begin lending that money. The natural result of this increased lending is a lower effective Federal Funds Rate because banks have to compete with each other when they are lending the money they have. If Bank A wants to lend more than Bank B, it has to lower its rates, which causes Bank B to lower its rates to keep up---and the cycle goes on until both banks reach the lowest rate at which they can still turn a profit.
A lower effective Federal Funds Rate means businesses can borrow money at a lower rate, merger and acquisition deals can find capital, and hedge funds can borrow money to leverage their accounts. The hope is that lower rates will help keep the economy growing, but only time will tell. We'll have to keep an eye on the Fed to see what else it has up its sleeve.
Credit given to PFXGlobal . Ok folks, economy class dismiss :)
Read Also :
- The Fed With Their Burning Ass
- Bear Stearns Sold, Fed Cuts Rates, Asian Stocks Sharply Lower
By S. Wade Hansen, 13 August 2007
The U.S. Federal Reserve (The Fed) has been injecting billions of dollars into the financial markets to maintain liquidity amid rising interest rates. But how could interest rates be rising? Doesn't the Fed set interest rates? The answer is "Yes," but the open market has its say too. Let me explain.
The Fed sets both the Discount Rate and a target, or objective, for the Federal Funds Rate. However, while the Fed can ensure the Discount Rate does not fluctuate throughout the day, it cannot ensure the Federal Funds Rate wilI not fluctuate. The Fed has to walk a fine line in the open market to keep the Federal Funds Rate in line with its target rate.
The Discount Rate is the interest rate at which banks in the Federal Reserve System can borrow money from the Fed at the discount window.
The Federal Funds Rate is the rate banks charge each other as they lend their balances at the Federal Reserve to one another.
The liquidity crunch that people have been talking about has been caused by a rising effective Federal Funds Rates, not by a rising Discount Rate. This means that banks are charging each other more than the target Federal Funds Rate of 5.25 percent to borrow on each bank's reserves, respectively. To combat this problem, the Fed has been injecting money into the markets.
The more cash that banks have available to them, the more likely they are to lend. Banks don't make money by sitting on cash. They make money by deploying that cash and charging interest. When the Fed injects huge amounts of cash into the banking system, banks begin lending that money. The natural result of this increased lending is a lower effective Federal Funds Rate because banks have to compete with each other when they are lending the money they have. If Bank A wants to lend more than Bank B, it has to lower its rates, which causes Bank B to lower its rates to keep up---and the cycle goes on until both banks reach the lowest rate at which they can still turn a profit.
A lower effective Federal Funds Rate means businesses can borrow money at a lower rate, merger and acquisition deals can find capital, and hedge funds can borrow money to leverage their accounts. The hope is that lower rates will help keep the economy growing, but only time will tell. We'll have to keep an eye on the Fed to see what else it has up its sleeve.
Credit given to PFXGlobal . Ok folks, economy class dismiss :)
Read Also :
- The Fed With Their Burning Ass
- Bear Stearns Sold, Fed Cuts Rates, Asian Stocks Sharply Lower
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