FED Basics: What Does Slowing the Economy Mean?

Every day you hear it, whether Ben Bernanke had the sniffles or whether one of the Fed governors made a statement about the economy: every investor is afraid that the Fed will act to “slow the economy.”

What exactly do journalists mean by this?

The Federal Reserve is charged with keeping inflation steady, and in order to do so they have control over two major interest rates: the Discount Rate and the Fed Funds Rate. Both are interest rates charged to banks for overnight loans.

The discount rate is the interest rate charged to banks toat loan funds directly from the Federal Reserve.

The Fed Funds Rate is the interest rate charged to banks that borrow from other banks at the Fed.

The Fed Funds Rate is the more important figure, since most banks would prefer to borrow from other banks than directly from the Fed.

While neither of these interest rates directly affect investors, they do affect banks and lending rates across the spectrum. If banks have higher interest for short-term lending, then that will trickle down to their customers having higher rates for lending as well.

The bottom line is, when these interest rates are low, then it is easier to borrow money. If the Fed acts to raise these rates, it is said to be “slowing the economy,” since it gets more expensive (harder) to borrow money as interest rates climb.

This higher interest rate leads to less borrowing and, hence, less spending and a general decrease in business transactions.

So, when some journalist frets about the Fed possibly “slowing the economy” or “Tightening the money supply” (another favorite), what they are really talking about is rising interest rates.

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