A closer look at Fed Rates

On Aug 17, 2007 before the US markets open, the Fed surprised everyone by reducing its discount rate from 6.25% to 5.75%. The Fed Funds rate remained at 5.25% and the Prime rate has also not changed, and stayed at 8.25%. As a result, the markets were greatly encouraged and rallied.

What do these rates mean?

Fed Funds Rate: The Fed Funds Rate is the overnight interest rate at which U.S. banks lend to each other their excess reserves held on deposit at the U.S. Federal Reserve.

Discount Rate: The Discount Rate is the overnight rate at which U.S. banks can borrow from the U.S. Federal Reserve.

Prime Rate: The Prime Interest Rate is the interest rate charged by banks to their most creditworthy customers (usually business customers). The rate is almost always the same among major banks. Adjustments to the prime lending rate are typically made by banks at the same time.

What does the discount rate reduction mean?

The cost to banks for borrowing from the Fed has dropped, while the rate they earn loaning to each other and the rate they charge their customers has not dropped. That means they make more money when they loan today than they did last week. That means banks are somewhat more likely to lend and that the economy will be somewhat more liquid. That presumably will help reduce investor worries in the bond and stock markets over the liquidity aspects of the current debt crisis.