The Federal Reserve exists to keep prices stable, employment high and the economy growing. It accomplishes these tasks by manipulating the amount of money in circulation. When the economy slows down or enters recession, consumers and businesses have less money to spend. The Fed stimulates recovery by lowering interest rates. Lower interest rates reduce the cost of loans and debt. Consumers and businesses borrow more, which in turn lets them spend more, putting more money back into the system.
The Federal Funds Rate
By law, banks must hold a certain amount of cash in reserve to meet unexpected cash outflows, such as everyone trying to withdraw their money at the same time. Banks borrow money to keep their reserves at the mandated level, and the Fed sets the interest rate. This is known as the federal funds rate. The lower the federal funds rate, the more money banks tend to lend, as they can cheaply borrow the cash they need to make loans.
The federal funds rate is the benchmark rate against which other interest rates are set. Thus, when the federal funds rate falls, other interest rates tend to fall -- among them the prime rate, which commonly provides the base rate for commercial loans, mortgages and other forms of consumer borrowing. A reduction in these interest rates means cheaper debt. This encourages consumers to borrow, and to spend the money they borrow on durable goods, such as a new car.
Cheap Debt Stimulates the Economy
Cheaper debt also encourages businesses to expand. In addition, consumers who carry debt such as a mortgage or a car loan may see their monthly payments go down if they are not locked into a fixed rate. Both consumers and businesses have more disposable income, which increases overall spending. The effect filters through the entire economy. For example, homeowners are able to take out cheaper home improvement loans to pay for labor and building supplies. This leads to an increase in the sale and production of timber, which typically reduces prices. Jobs are created in the construction industry and the overall economy grows.
Borrowers Benefit, Savers Suffer
When the Fed lowers interest rates, homeowners with adjustable rate mortgages should see their monthly payments go down. Potential home buyers benefit from more affordable mortgages, which typically brings new entrants to the housing market. Consumers with credit card interest rates and other loans linked to the prime rate should also see their rates come down. However, someone who keeps his savings in a bank earns less money on his nest egg when rates go down.
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