Fed Funds

Essay by PaperNerd ContributorUniversity, Master's September 2001

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"Fed slashes federal funds rate by one-half percentage points"�. This is what many headlines read after the Fed surprisingly between meetings, cut the short-term interest rates to 4.5%. In reaction to such a surprise, the Nasdaq Composite ended the day up 156.22 points while the Dow soared up 399.10 points. There are numerous reasons as to why the Fed controls interest rates and why in this case there was a surprise cut in the rates. Some of the reasons can be more opinionated than others.

First I will briefly describe what exactly cutting the interest rate means and what exactly it does. The federal funds rate by definition is the rate at which banks charge each other for inter-day or over-night loans. Banks make loans through the federal funds market to insure that their reserves meet the quota. Banks are required to have a certain amount of reserved money set by the Fed. So if they loan out too much than they will need to make quick loans to meet the Federal reserve. The Fed simply acts as an intermediary as they transfer debt and give credit to other bank reserves. In this open market, the cost of borrowing and returning is the federal funds rate. This rate is not actually changed by the Fed as one would assume when these announcements are made. The Fed actually has no direct control over the rate. The Fed has a Federal Open Market Committee meeting every six weeks to choose a federal funds target. This target is reached through open market operations. Open market operations consist of either selling or buying financial assets. The rate also does not automatically go to the rate at which the Fed announced it would be. The rate is reached by trial and error. To...