By the time this week’s Blount Today is distributed, we will know part of the “rest of the story.” The Federal Reserve met Tuesday, and by now we know whether they took very aggressive action with a three quarter point or perhaps a one full point rate reduction, or if their action was less aggressive by lowering the rate by a half point. The rate they are adjusting is the federal funds rate.
For the U.S., the Federal Reserve is the primary institution in charge of keeping our monetary policy in balance. It has two primary objectives. The first is to keep inflation in check with the second being to keep our economy growing. While most may believe the only tool the Federal Reserve has to use is the adjustment of the federal funds rate, their arsenal is deeper than we thought. Chairman Ben Bernanke and the Federal Reserve Board have demonstrated creativity with the variety of steps they have taken to resolve recent credit issues and to stimulate our economy.
The most widely known tool of the Reserve is the adjustment of the federal funds rate. This is the rate private institutions such as banks lend money at the Federal Reserve to other depository institutions, generally overnight. So, when banks need to borrow short-term money, this is the rate charged when borrowing from other banks. Banks or other depository institutions can also borrow directly from the Federal Reserve. This monetary process refers to the use of the Discount Window. Funds borrowed here are generally short-term, but longer than overnight. The interest rate at the Discount Window is also set by the Reserve, and there are several rates the Reserve uses.
The ability for banks to borrow funds at lower rates generally trickles down through other types of rates eventually impacting the public. Credit card rates may follow adjustments to the federal funds rates; but if they do, it is very slow when declining and faster when rates are increasing. Mortgage rates are also impacted by changes in the federal funds rate; but again, it is not always in direct correlation. The prime rate is the rate that most directly follows any changes to the federal funds rate. This is the rate most businesses use as a basis of their lending. If the prime rate declines, then businesses are paying less interest and their profits may increase. Thus, this is one reason investment markets are very interested in movements in the federal funds rate.
Part of the crisis we have seen in our current economy is the lack of liquidity. Many of the major financial institutions provide initial capital in the process of loans. If the institutions do not have cash to pay at closing, they cannot provide the loan. As many of you may have experienced, a lender may have agreed to loan you funds for your home purchase. However, shortly after closing on the purchase, you find out a new company will be servicing the loan. What has occurred is a typical process in our economy. The lender, who has provided the cash, now needs more cash to close on additional loans. To achieve this, they sell the loan they have just made and take the new cash to close on the next loan. This works fine when there are buyers of the loans the banks have made.
In recent months, some of the loans or loan packages that have been sold have been determined not to be worth what the purchaser paid. Without going into all of these details, you can now see that if the buyers of these loans stop purchasing them, then institutions run short of cash to lend and in some cases to be able to pay normal obligations. The Federal Reserve has stepped into the markets by becoming an intermediary and thus to provide stability to our credit system. This was achieved by offering to swap on a temporary basis certain loan packages lenders could not sell for U.S. Treasuries which could be easily sold.
Many of the historical U.S. recessions have been short in duration and the investment markets returned to their pre-recession levels in less than six months following the end of the recession. The length and depth of this recession (or economic slowdown) will depend upon the actions by the Federal Reserve. Thus far, the Reserve has demonstrated creativity, responsiveness, and willingness to act. While some may say they were behind the curve, recent steps may be sufficient to get our economy back on track. Only time will tell whether these and additional steps by the Reserve if any are all that is needed for our economy. Hence, the rest of the story of this economic slow down or recession is dependent upon the Federal Reserve and the stimulus package provided by Congress.
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Doug Horn, CFP, is an area financial planner with more than 24 years financial experience and founder of Quality Financial Concepts, located in downtown Maryville on Broadway.
Doug Horn, CFP, Registered Investment Advisor in Tennessee and Texas and Registered Principal, Branch Office of and Securities offered through CUE Financial, Member FINRA, SIPC.