Tooling Around

Story Highlights:

• The Federal Reserve lowered the nominal federal funds rate from 1.5% to 1% on Wednesday.
• The Fed's move on Wednesday was highly anticipated and partially a formality. The effective fed funds rate has been trading lower than the target rate for some time.
• Manipulating the fed funds rate has less significance now than in more normal times—there have been many monetary policy tools put into play during the financial crisis.

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The Federal Reserve the nominal federal funds rate from 1.5% to 1% on Wednesday. Markets were following news of the half-point cut before ending the session down.

The Fed's move on Wednesday was highly anticipated and partially a formality. The fed funds rate is the overnight interest rate banks charge each other to borrow funds to meet reserve requirements. The Fed can perform open market operations and purchase and sell Treasury securities to try to move the fed funds rates toward a target rate it has set—the nominal fed funds rate. But the actual fed funds rate is negotiated between the lending and borrowing bank in the fed funds market and often falls within a range of the target. Since October 10th, the effective federal funds rate—the volume weighted average of all negotiated market bids and offers between banks—has been the target rate. Setting the target rate closer to the effective rate merely reflects reality rather than hugely changing it.

Manipulating fed funds rates is a standard monetary policy tool the Fed often deploys to affect economic growth and inflation. Pushing down fed funds rates encourages banks to borrow to take advantage of the cheap rates and in turn provide better lending rates to consumers and businesses. In the past, small movements in the fed funds rate produced large effects on other interest rates including corporate bond rates and mortgage rates. But Wednesday's rate cut was just window dressing and widely expected. The fed funds rate plays less significance now than in more normal times—besides the target fed funds rate reductions, the Fed has deployed a number of other monetary policy measures over the course of the financial crisis to provide liquidity and stabilize the economy.

Some folks worry if fed funds rates are cut to zero, the Fed would be limited in its options to help the economy if conditions worsened or if prices started to broadly fall. But the Fed has demonstrated time and again it isn't afraid to implement aggressive and even unprecedented policy moves. It's likely an amalgamation of these various tools, rather than reliance on one, that will help monetary policy guide eventual financial and economic recovery.