The Federal Reserve Board responded to the economy yesterday by lowering the target for the federal funds rate to 1% and the discount rate to 1.25%.

The first number is the rate usually in the news. The federal funds rate is the interest rate that banks charge to lend their balances to one another. If one bank wants to loan $30m to another bank, the two companies can negotiate the rate and the lending back and charge the borrowing back the rate agreed upon. By lowering the federal funds rate target, the Fed is saying they’d like to see this interest rate around 1%. The true lending interest rate is controlled by the market, guided by the Fed.

When banks borrow money from the Federal Reserve, the discount rate serves as the interest rate for the loan.

The federal funds target rate hasn’t been as low as 1% since June 29, 2004, having reached that level over a year before on June 25, 2003. A low target rate, and the ensuing availability of easy credit, possibly contributed to today’s credit crisis. But today’s low target rate will have a different effect, according to the policy makers. They believe low rates will increase liquidity between banks and encourage more—but sensible—consumer lending.

It might not be enough. Here’s the important part of the Federal Reserve’s statement yesterday:

Recent policy actions, including today’s rate reduction, coordinated interest rate cuts by central banks, extraordinary liquidity measures, and official steps to strengthen financial systems, should help over time to improve credit conditions and promote a return to moderate economic growth. Nevertheless, downside risks to growth remain. The Committee will monitor economic and financial developments carefully and will act as needed to promote sustainable economic growth and price stability.

“Downside risks” and “will act as needed” probably signal more rate cuts to come in the future. But there isn’t much further you can go from here. The Federal Reserve could cut the target rate to 0%, but that would be a first, I believe. If banks still aren’t lending to each other at that point, the only other option is simply printing money.

Inflation would increase, making it more difficult to afford the same living standards unless inflation is accompanied by growth in salaries. The current jobs market doesn’t make salary growth seem likely.

So what does this mean for me?

The moves by the Federal Reserve don’t affect interest rates on consumer loans. Rates on long-term mortgages will not change dramatically due to changes in the federal funds rate or the discount rate. Adjustable rate mortgages might see a decrease in interest rates. Many ARMs are tied to a different rate entirely, the LIBOR. The LIBOR has been slowly decreasing, as well.

Savers are in for bad news. Interest rates offered by banks for savings account usually follow the movements of the federal funds target rate, but some banks may follow the LIBOR movements. A number of banks have decreased their interest rates recently, and I expect that to continue.

The Federal Reserve may soon become much more powerful if Treasury Secretary Henry Paulson has his way. Earlier today, he released the “Blueprint for a Modernized Financial Regulatory Structure,” which includes a number of recommendations designed to take power away from the U.S. Securities and Exchange Commission.

Paulson’s recommendations

The Federal Reserve should be able to increase liquidity by lending directly to “non-depository institutions” (such as investment banks), and to facilitate this, the Fed will have access to information at the investment banks. The government would have the power to perform on-site inspections if they so desire in an effort to quickly lend to the businesses if necessary.

Paulson wants the Federal Reserve to create a Mortgage Origination Commission to oversee and rate how states license and regulate lenders and create minimum qualification standards for licensing.

The Treasury Secretary believes the Federal Reserve should regulate state-chartered banks, payment systems, and insurance companies. The SEC would merge with the U.S. Commodities Futures Trading Commission to oversee traditional investments as well as some of the more complicated structures.

With these suggestions implemented, the government will regulate “business conduct” ensuring consumer protection, including rules for writing term disclosures across the board of financial products.

Reactions

Nomi Prins points out that the Federal Reserve has spectacularly failed recently with its attempts to stimulate and regulate, so providing more power to the agency is a step in the wrong direction.

All of the plan’s suggestions are cosmetic. Instead, let’s please have a serious discussion about the nature of the banking system structure itself: its complexity, its responsibility, and the proper role of the federal government in regulating it. The United States has had such a debate before, leading up to the landmark 1933 Glass Steagall Act. We can and should have such a sweeping debate again.

Traditional small-government Republicans would most likely agree with Nomi. The Democrats are critical of the plan as well, saying the proposal doesn’t go far enough to provide direct help to consumers and to hold investment banks as accountable as depository banks.

I agree that regulation should be consolidated for all financial firms and the same standards for reserve holdings should apply to any institution that has access to direct lending from the Federal Reserve. What do you think?

Image from Wikipedia
Treasury Releases Blueprint for Stronger Regulatory Structure [U.S. Department of the Treasury]

While I was having dinner with my father last night, the Federal Reserve lowered the interest rate at which it loans money to central banks. While my family and I were discussing the economy (among a number of other more interesting topics), Ben Bernanke was actually doing something. Will the move help? It will be good for JP Morgan Chase, who will likely use the Fed’s funds borrowed at this rate to buy its collapsed rival, Bear Stearns.

Do these bail-outs send the right message? To me, in the interest of saving our faltering economy, the message to banks seems to be, “Feel free to lend to risky customers. If the worst happens, we’ll bail you out.” The message to consumers seems to be, “Buy more on credit than you can afford as long as everyone else is doing so.”

Sunday surprise: Fed steps into credit crisis [CNN Money]

On my way into work this morning, I heard that Ben Bernanke and the Federal Reserve Board cut the target rate for banks’ short-term lending to 3.5%. This makes it more worthwhile for banks to take on more risk with their money, lending it out in cases where they’ve been tight lately. The Fed announced this change between meetings, not at a meeting as normal announcements, in response to the free-fall that the world financial markets seem to be experiencing.

It will be interesting to see how the market reacts today. You could argue that if the U.S. stock market doesn’t drop 5% as it was expected to do today without the emergency rate drop, investors don’t think that this move by the Federal Reserve will help solve the economic problems.

When the Fed rate drops, so do interest rates on savings accounts. A significant drop of three quarters of a percentage point may mean it’s time to rethink saving strategies; if you can’t earn from your savings more than you are paying in interest on debt, then it may be time to forgo extra savings to pay off loans.

As expected, ING Direct was the first bank to lower savings and checking interest rates today in response to the Federal Reserve Board’s interest rate reduction.

ING DIRECT’s Orange Savings Account has changed to 4.20% APY.

The rates for the Electric Orange Checking Account have changed as well. The new tiers are:

• $0-49,999.99 earns a 3.25% APY
• $50,000.00-$99,999.99 earns a 4.75% APY
• $100,000.00 or more earns a 4.90% APY

I expect more banks to follow