What interest rate does the fed cut?

February 2008 - Most of you have heard that the "Federal Reserve Bank (I'll use fed from here on) cut interest rates by 50 basis points" this past week. What the heck does that mean? Hopefully I can provide some clear insight for you.

First of all, there is not one interest rate. There are two. The discount rate and the Fed Funds rate, respectively. Both are different. And how the fed adjusts them is very different. Let's start with the discount rate which is easier to understand.

In this example you're a bank. You lend money to your mom, dad and lazy brother (if you're wondering, none of my brothers are lazy in reality). Mom and dad pay back their loan, but your lazy brother defaults. As it turns out, the asset backing the loan (e.g. house) has depreciated. Meaning you, as the bank, paid more for what you're getting in return after your lazy brother files for bankruptcy. Remind you of the current subprime mortgage issue? It should.

The bad loan made to your lazy brother puts you in a crisis. You just lost a ton of money and now to stay on your feet, you need to take a loan out yourself. This is where the fed comes to your rescue.

We all need banks. Even banks need banks. And when a bank needs to get a loan from their bank (i.e. the fed), they can loan money from the fed at the discount rate. That is, the discount rate is the interest rate banks get charged for borrowing money from the fed. Wouldn't it be nice to have a line of credit from the fed!

Now the Fed Funds rate is a bit different. The Fed Funds rate is simply the interest rate that banks charge other banks. Remember that lazy brother that put your bank in a crisis? Well to cover your losses, you could borrow the money from another bank instead of the fed. In fact, in recent history, borrowing money from the fed has been a sign of weakness. Thus, most banks prefer to lend from their contemporaries instead of crawling into the fed and talking to Bernanke.

The fed does not set the Fed Funds rate, but they do strongly influence it. This gets a bit complicated, so I'll try to keep it real simple. Remember supply and demand from college? Supply goes up, prices go down. Supply goes down, prices go up. Keep this in mind as you follow me.

If the fed purchases Treasury Bills from the market the amount of money available is increased. That is, the money supply goes up. As the money supply goes up, interest rates go down. The inverses is also true. If the fed sells Treasure Bills, they collect the money thus reducing the money supply. Reducing the supply of money, makes prices go up. That is, the interest rate goes up.

Understanding the Fed Funds rate is confusing, I totally admit. Even after taking almost three years of business classes, I'm not 100% sure I even understand it. But don't worry. You don't really need to understand all this. And if you don't, you're in good company as most people simply know that if the fed raises or lowers some interest rate, their interest rates (e.g. car, CD, money market) will most likely go up or down as well.

Here we have it. Next time the fed decides to cut an interest rate, first find out which one, and second remember back to my blog when we opened this conversation.