Why does the Fed Reserve cut interest rates?

The Fed Reserve cuts interest rates to provide more money supply in the economy and stimulate consumer spending. The Fed usually fiddles around with two interest rates, which in turn impact all other consumer interest rates.

  1. Federal Funds Rate: The Federal Funds Rate is the rate that is used to ultimately determine the rate of interest that people pay on their credit cards, home equity lines of credit and car loans. On October 29, 2008, this rate went down to 1%, which is the lowest it ever got during the last twenty years or so. The highest it got in the last twenty years was in July 1990, when the Fed Funds Rate was 8%.
  2. Federal Discount Rate: Federal Discount Rate is the rate of interest at which banks borrow money from the Federal Reserve. Banks have to maintain certain statutory cash reserves with them. In order to do that, they usually borrow money from other banks. Using the Fed for this, is usually the last resort. They go to the Fed when the liquidity in the market dries up and other banks are reluctant to lend to them. A recent example of liquidity drying up was seen during the credit crunch.

Fed uses these interest rates to control the supply of money in the economy and that in turns influences the interest rates, inflation and even the currency exchange rates in the economy.

In times of economic downturn, Fed cuts the interest rates in the hope that people will have access to cheap money. Once they have access to cheap money they will spend it in stores like Circuit City and Linens-N-Things and help them stay afloat.

When the economy stabilizes, the Fed will slowly start hiking up the interest rates to control the inflation and not let the economy over-heat. These are tools used by central banks all over the world with the same effect.