Fed Cuts Rates by Half-Point

The Federal Reserve's Open Market Committee announced a half-point cut in its target for the short-term federal funds rate, to 5%. While half-point cuts are generally seen as significant moves, today's is practically a cautious one compared to the speculation in recent days of a three-quarter point or even full-point cut.

In its news release, the Fed cited several factors behind its decision, including falling consumer confidence and business inventory buildup, noting that "Persistent pressures on profit margins are restraining investment spending and, through declines in equity wealth, consumption. The associated backup in inventories has induced a rapid response [i.e., a decline] in manufacturing output and, with spending having firmed a bit since last year, inventory adjustment appears to be well underway."

The Fed also stated that "Although current developments do not appear to have materially diminished the prospects for long-term growth in productivity, excess productive capacity has emerged recently. The possibility that this excess could continue for some time and the potential for weakness in global economic conditions suggest substantial risks that demand and production could remain soft." With that in mind, it's no surprise that the Fed maintained its bias toward cutting rates.

How does the Fed work?
As noted in our special on the Federal Reserve, the Fed does not actually directly control the short-term federal funds rate, which is the rate banks pay each other for loans to top off their required reserves. Instead, the Fed's decisions are actually changes to its target for the rate, and it nudges the rate up or down toward its target by either buying or selling government securities.

When buying government securities, the Fed creates reserves -- essentially, new money -- to pay for them, thereby increasing the supply of bank reserves, increasing money in the economy, and reducing the need for borrowing by member banks, which reduces the federal funds rate. When the Fed sells securities, it reduces reserves held by the banks of the purchasers of those securities. This makes it more likely that banks will engage in overnight borrowing, which then increases the federal funds rate.

For a more extensive explanation of how all this works, check out How the Fed Affects the Economy.

Chris Rugaber does not own shares of the Federal Reserve, nor does anyone else. The Motley Fool is investors writing for investors.

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