Richmond Virtual Village: Finances: Basics: Governtment

How the Federal Reserve affects you

Perhaps no institution has more power to affect the nation's economy than the Federal Reserve (Fed) the central bank established by Congress in 1913. Under the leadership of its chairman, Alan Greenspan, the Fed steers the economy. Most directly by raising and lowering the federal funds rate, which banks charge to each other on overnight loans. Such rate changes can take six to nine months to work.

Who sets the rates?
Fed policy changes frequently are attributed to the central bank's Chairman, Alan Greenspan, actually they are made by the 12-member Federal Open Market Committee. The FOMC has eight scheduled meetings a year.
Board of Governors. The seven Fed governors, including Greenspan, are appointed by the president for 14-year terms. All are permanent members of the FOMC.
Regional Fed presidents. The New York Fed president is a permanent member of the FOMC. Of the remaining 11 regional presidents, four sit on the FOMC at a time.

When rates go up
Raising interest rates is considered an effective way to quell inflation. The Fed raised rates six times over the 11 months ending in May 2000 to keep the economy from overheating.
Businesses: Higher interest rates make it more difficult for businesses to get loans to expand. Unemployment tends to rise, which eases wage inflation, although at a human cost.
Consumers: Higher interest rates on credit cards and mortgages can cool consumer spending, which accounts for about two-thirds of economic activity.
Markets: Higher interest rates tend to attract investment into bonds and other fixed-income investments, pushing down stock prices.

When rates go down
The Fed generally cuts interest rates when inflation is subdued and the economy needs a boost. The Fed cut rates in January for the first time in two years in response to a sharp economic slowdown.
Businesses: Lower rates cut the cost of capital, improving profit margins and encouraging expansion.
Consumers: Lower interest rates can create economic activity by inducing consumer spending. For example, lower mortgage rates can spark home sales and mortgage refinancings. But the Fed's ability to affect such long-term rates is indirect.
Markets: Lower interest rates tend to boost stock prices because bonds and other fixed-income investments are no longer so attractive. In addition, lower rates cut costs for companies, boosting profits.

Federal funds rate: The lowest of short-term market interest rates, which banks charge each other on overnight loans. The Fed sets this rate by buying or selling government securities until the target level is achieved.
Discount rate: Applies to loans made directly to commercial banks by the Fed. Generally set one-half percentage point above the federal funds rate. Because the Fed makes such loans only rarely, the rate is considered largely symbolic.
Prime rate: Charged by commercial lenders on short-term loans to their lowest-risk, most creditworthy customers, such as large corporations. Often serves as a basis for rates on other loans.