Tuesday, December 11, 2007

Fed Rate Cut, A Layman's Guide to Fed Policy

The Federal Reserve Board will announce today whether or not they will reduce the rate which they charge banks to borrow money overnight. This is always a highly anticipated announcement and guessing what the Fed will do and when has become an industry unto itself. What's all the fuss about? Here's the simplified version:

Cash is a product, like any other. It's an "avatar" for wealth. A tool for facilitating wealth and asset transfer. A substitute for direct barter. Banks "sell" cash to customers, who pay them back with more cash (loan plus interest). The banks get their inventory (cash) from customers who deposit money with them. Banks are not allowed to lend out all of their inventory. They have to keep a certain percentage on hand to cover withdrawal requests. When the bank's inventory of cash falls below required levels, the bank borrows money from the Federal Reserve overnight to cover the shortfall.

When banks are faced with increasing slow pays and defaults, the amount they must borrow overnight increases. This causes costs to go up, which are passed on to consumers down the line. This is why the Fed's overnight lending rate is so closely watched and why it can be a useful tool in affecting spending behavior, at least short term. When the Fed lowers the rate, banks can afford to cover more shortfalls for longer periods of time and aren't under as much pressure to raise their lending rates or take aggressive collection action.

When the Fed raises overnight rates, banks will often raise their own rates and/or tighten credit requirements to ensure a higher percentage of on-time payments.

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