Wednesday, September 19, 2007

US Federal reserve and its terminology

“Federal Reserve cuts key rate by 50 basis points”

Amidst fears that the subprime crisis is going to have a negative impact of the other sectors of the US economy and thereby speed up a much feared recession in the US, the Fed has cut the interest rate by 0.5% (100 basis points = 1%) from 5.25% to 4.75%. This reduction is expected to boost consumer spending and economic activity, thus ensuring that the US economy doesn’t go into a recession.

A paper headline like the one mentioned above, has three unknown terms for a novice. “Federal reserve”, “key rate” and “basis points”. Let me explain these terms for you today.

Federal Reserve System (also the Federal Reserve; informally The Fed) is the central banking system of the United States.

The Federal Reserve System is a quasi-governmental/quasi-private banking system composed of (1) the presidentially-appointed Board of Governors of the Federal Reserve System in Washington, D.C.; (2) the Federal Open Market Committee; (3) 12 regional Federal Reserve Banks located in major cities throughout the nation acting as fiscal agents for the U.S. Treasury, each with its own nine-member board of directors; (4) numerous private U.S. member banks, which subscribe to required amounts of non-transferable stock in their regional Federal Reserve Banks; and (5) various advisory councils.

The Federal Reserve System implements monetary policy largely by targeting the federal funds rate. This is the rate that banks charge each other for overnight loans of federal funds, which are the reserves held by banks at the Fed. This rate is actually determined by the market and is not explicitly mandated by the Fed. The Fed therefore tries to align the effective federal funds rate with the targeted rate by adding or subtracting from the money supply through open market operations. A reference to “key rate” in the news headline above, is to this federal funds rate.

The Federal Reserve System also directly sets the "discount rate", which is the interest rate that banks pay the Fed to borrow directly from it. However, banks usually prefer borrowing fed funds from other banks, even at a higher interest rate, rather than directly from the Fed, because that might suggest problems with the bank's credit-worthiness or solvency.

Both of these rates influence the prime rate which is usually about 3 percentage points higher than the federal funds rate. The prime rate is the rate at which most banks price their loans for their best customers.

Interest rates are usually mentioned by bankers in terms of basis points. 100 basis points equals 1%. Therefore, 50 basis points refers to 0.5%.