How do the federal interest rates work

fed2During this time of economic instability we hear a lot about the federal interest rates.  Are you one of those people who doesn’t know what the fed is?  Don’t be ashamed, you’re not alone.  A lot, maybe most people don’t know what it is or what it does. 


The short answer:  The fed is the bank’s bank; the watchdog of our economy. The fed sets the federal interest rates.  By controlling some aspects of the banking industry, it can affect the nation’s economy but before you can understand what that means, you need to understand the term, “liquidity.”


Think of liquidity like the blood that travels through your body.  Blood travels in a circular motion.  It starts in your heart travels through your arteries providing nutrients to your body and then travels back, get’s cleaned, picks up more oxygen and makes the trip again.  If the flow of blood stops, vital areas of your body are deprived of nutrients, eventually causing a chain reaction that brings the entire system to a stop.


Financial liquidity is simply when money starts at the Federal Reserve banks (the fed) which is leant in some form to other banks which is leant to you and me for our personal use or our businesses.  This causes us to spend that money which creates jobs and business revenues which brings the money back to the banks.  This flow of money insures that our economy stays nourished financially.


Sometimes this natural flow is somehow disrupted.  If, for example, this flow is so healthy that the costs of everything rises but wages don’t, called inflation, the fed will slow down the flow of money by raising federal interest rates.  When the cost of borrowing money goes up, the speed of that liquidity slows down.  When the opposite happens, called a recession, the fed lowers interest rates making borrowing money more attractive.  This speeds up the flow of money.


You may have heard the term, “credit freeze.”  That has been one of the buzz phrases in our current recession.  Because of some more complex conditions having to do largely with the housing market, our economy found itself frozen.  No matter what the fed did, banks wouldn’t lend to other banks, businesses, or consumers.  We had no liquidity in our financial system.  To go back to our body analogy, we were in financial cardiac arrest.


Although the financial bailouts aren’t popular, most agree that they are necessary.  The bailout money could be looked at as giving our heart, in cardiac arrest, bypass surgery.  By giving banks money to lend, they are expected to lend it.  Over time, as this liquidity returns, the economy will improve.


Now that you know what liquidity is, you understand a little bit more about the fed.  The fed’s main job is to keep the blood flowing at the proper speed and they do that by changing the federal interest rates.

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