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Understanding How Federal
Reserve Rate Cuts Work

By Blanche Evans

Have you ever wondered how the Federal Reserve works? Here's a brief synopsis.

The Federal Reserve is the central bank of the federal government and the privately-held guardian of the U.S. economy. It's composed of 12 regional banks that report economic conditions. Together, the heads of the banks determine many economic policies.

They collectively:

Regulate monetary and credit policies such as the buying and selling securities.

Set the cost of credit (interest rates).

Determine how much money and what terms are available to member banks for borrowing directly from the central bank (discount rates).

Determine the rates and terms member banks borrow money from one another (federal funds target rates).

There are two ways banks can borrow money using

Federally-insured funds. They can borrow money directly from the Fed using the "discount" rate, or they can borrow from each other using the "federal funds" interest rate. Both are short-term or overnight rates.

The discount rate is designed to improve liquidity for the banks themselves. The federal funds target rate rate is meant to impact consumer credit.

Because the Fed can't dictate what happens in the market, the Fed will issue a "target" rate for federal funds, which most banks stick close to. They can then charge consumers whatever they feel they can get away with in the form of credit card interest rates, mortgage interest rates, car loans and so on.

One thing the Fed does not do is set mortgage interest rates. The lenders do that based on such factors such as the yields from mortgage-backed securities. When the bond yields go down, interest rates follow. Bond yields go down when the market believes inflation is under control.

If that's true, mortgage interest rates will drop, and housing becomes more affordable.

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