Why the Feds Cut Rates
There is a lot of attention about the Feds cutting, and sometimes raising, rates. But what does this mean and why do they do it?
In short, the Feds cut (or raise) rates to adjust the amount of money in the economy (known as money supply). This practice is part of the Fed's monetary policy.
First, let’s explain which interest rate they are adjusting. It’s not the interest rates on credit cards, mortgages, auto loans, etc., however they are greatly influenced, but rather what's called the Federal Funds Rate.
This interest rate is what banks have to pay to borrow money. Yes, banks borrow money for many different reasons, primarily to lend to consumers. The rate they lend to consumer is higher than the rate they borrow at; the difference is a revenue and profit to the bank.
But as the bank’s cost of borrowing goes up or down, so does yours. So with a interest rate cut, new loans are issued at a lower interest rate. This affect soaks its way to the consumer in terms of lower interest loans on mortgages, credit cards, auto loans, etc.
So why does the Federal Reserve Bank intervene in our economy in this manner? While there are many factors the Feds monitor, such as consumer spending and wage growth, one making headlines is inflation. The Feds have a target inflation rate, which is reflective of a "healthy" economy, of around 2%. This means the feds want to see a general increase in the price of goods of 2% each year. For a while, inflation has been below the Fed's target of 2%. In order to increase inflation, money has to be "cheap" and accessible to consumer. The goal is for consumers to borrow (at attractive interest rates) and spend. With increased spending, the prices of goods tend to rise which helps inflation rise.
Keep in mind that there are multiple factors considered when the Fed decides to adjust rates.
With the economy doing relatively well: low unemployment and the stock market setting all time highs, why would the Feds cut rates which is usually indicator that the economy needs help? Again many factors are involved but there are signs of slowing global growth, wage growth remaining flat, low inflation rates, uncertainty around trade tariffs and these could result in a recession for the economy.
The decision for the Fed to cut rates is being called "an insurance cut" to get ahead of these indicators before they can affect the economy.
As time goes on, we will see if the cut indeed provided insurance against a recession.