What Does it Mean When the Fed Cuts Interest Rate?

When financial analysts and forecasters talk about stock market predictions, there are always mentions of whether or not the Fed will cut interest rates.

Apparently, ordinary folks are not too familiar with how everything else can be affected if the Feds decide to cut or not to cut interest rates. Perhaps, answers to the following questions could give some clarity:

Who is the Fed and What is Its Authority to Cut Interest Rates?

The Fed refers to the 12-member Federal Open Market Committee (FOMC) consisting of (1) The president of the Federal Reserve Bank of New York; (2) The seven members of the Board of Governors of the Federal Reserve System and (3) The 4 other presidents of Federal Reserve Banks representing each block of 4 Federal Reserve Bank Groups, with each member serving annual terms determined by way of a rotation system. .

The Four Fed Groups consist of eleven Reserve Bank presidents, grouped as follows:

  • Boston, Philadelphia, and Richmond
  • Cleveland and Chicago;
  • Atlanta, St. Louis, and Dallas; and
  • Minneapolis, Kansas City, and San Francisco.

Those 12 FOMC members meet regularly to discuss and decide on federal monetary policies, including decisions over changes brought on by events, which at times make it necessary to “cut the interest Rate.”

Although other U.S. states have Reserve Bank presidents as well, they represent the NonVoting Reserve Banks to which attendance at regular FOMC meetings includes participation in discussions, assessments and formulation of monetary policies affecting the economy of country.

What Kind of Interest Rate Do the FOMC Members Decide On?

The rates, which the Fed “cuts” is a target rate that serves as guidelines for banking institutions. This is in use whenever a reserve bank extends an overnight reserve loan to another reserve bank, to which the interest charge that will apply will be within the target rate established by the FOMC.

Why Do Reserve Banks Borrow from Each Other?

If at the end of a certain banking day, the total amount of bank transactions processed through a reserve bank resulted to a deficit, securing a loan from another federal reserve bank becomes necessary. That way, all federal reserve banks will reflect sufficient reserve balances at the end of each banking day, whilst the borrowing reserve bank will have to immediately settle the amount borrowed to cover the deficit.

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How Does the “Cut Rate” Affect the Regular Banking Institutions

Bear in mind that federal reserve transactions are exchanges of the monetary values related to the banking activities of bank customers, depositors and entities availing the products and services of regular banking institutions.

If the FOMC decides to reduce the target rate, which in the banking industry will be known as the “Nominal Rate,” it means the charges imposed by banks on its clients will likewise go down. The opposite happens, in case after deliberation and discussions, the FOMC votes to increase the target rate or the federal funds rate.

Any change creates a domino effect if the primary basis for the short-term or long-term interest loan rates, foreigh exchange rate, credit card fees and charges will go up or down, as it can also affect other economic variables connected to every monetary transaction.

The main significance of the Fed cutting the rate is that it will bring down costs to encourage more economic activities transpiring at low risk of inflation.