Last week we saw the Federal Reserve taking greater steps to try and stem the tide of economic decline here in the United States. Interestingly, we also saw central banks around the world taking similar actions, with China and Norway cutting rates along with the United States.

It is also interesting to note that the Federal Reserve did not consider high inflationary pressures as a concern while cutting rates. It was the first time in months that inflation was not mentioned. Immediately following the rate cut, we saw the Dow Jones gain almost 300 points and the Nikkei up almost 3.5 percent. The Fed also indicated that there would be more rate cuts to come, saying “the downside risks to growth remain.”

What does all of this mean? Does the Federal Reserve really have any control over the stock market? How can rate cuts here affect the Nikkei index in Asia? What rates are we cutting? And who is this Ben Bernanke character? With rates approaching historic lows and the economy still on a slide, we at The Warrior thought it would be a good time to educate our readers on what exactly the Federal Reserve does.
Let’s start with rates. The Federal Reserve has direct control over two rates; the federal funds rate and the interest rate. The federal funds rate is the rate at which private depository institutions can lend federal funds to each other overnight. Banks are required to maintain a certain level of federal funds at the Federal Reserve. In essence, this rate is the rate at which banks can trade federal funds overnight with each other.

The actual rate is determined by the market; the rate the Fed sets is the target rate. The Fed will try and align the target rate with the actual rate by adding or subtracting from the money supply.

The interest rate is the rate at which banks and private depository institutions can borrow from the Federal Reserve. This rate generally follows exactly with the federal funds rate, but at 100 basis points (1 percentage point) above. This encourages private institutions to seek all other forms of borrowing before coming to the Federal Reserve.

So what? What does any of this have to do with the stock market? The amount of money in the economy and the availability of that money to consumers has a direct impact on consumer confidence and spending.

If banks are not encouraged to lend money to consumers, consumers will have less money to spend. If consumers have less money to spend, there will be less of a demand for many goods. Lower demand equals lower prices. Lower prices are good in a robust economy, but when people are looking for work it’s not such a good thing. So the Federal Reserve cuts interest rates when the economy is in a slow down.
You might be asking, what’s the downside to cutting rate? Well, if banks are encouraged to lend money, more consumers will have money. Take the train of thought in the above paragraph and reverse it; you’ll end up with higher prices at the end. Inflation is the major downside, and it’s something the Fed watches closely.

Now that you have a better understanding of how the Federal Reserve works, you can apply it to your life. Keep an eye on what the Fed is doing; it will have a direct effect on your life now and after graduation.

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