Why Cuts To The Fed Funds Rate Spur The Economy Forward

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In June 2004, the Federal Reserve started a string of 17 consecutive rates hikes that lifted the Fed Funds Rate to 5.250%.  This caused Prime Rate to rise, too, because Prime Rate is always three percentage points higher than the FFR.

In mathematical terms, it looks like this:

(Prime Rate) = (Fed Funds Rate) + (3.000)

The Fed Funds Rate itself doesn't have much importance to everyday Americans because it's an interest rate used chiefly in bank circles.

As the interest rate upon which $2.5 trillion of American credit card debt is based, however, Prime Rate does hold water; each adjustment to Prime Rate can have dramatic impacts on the economy.

This is one reason why the Federal Reserve uses the Fed Funds Rate to speed up and slow down the economy.  As FFR rises, the amount that Americans pay in interest charges rises, too, leaving less money to buy things like this halitosis detector.

So, this summer, when the Fed sensed that the economy may be slowing down a bit, it wanted to pilot a soft landing.  Starting in September, it began to ratchet the Fed Funds Rate lower.

Today, the Fed Funds Rate (and Prime Rate) are 1.000% lower than their summer peak, checking in a 4.250% and 7.250%, respectively.

And, as the banks' cost of borrowing has fallen, so has the average American's cost of credit card debt.  This works the Rate Hike Scenario in reverse -- with less money spent on interest payments, more money is available to pump back into businesses.

The 1.000% rate cut equates to a one percent savings on $2.5 trillion in debt, or $25 billion dollars annually. 

This is how cuts to the Fed Funds Rate can spur the economy.

After the weakness in jobs data, markets are expecting more rate cuts at the Federal Open Market Committee's next meeting January 29-30.  Each quarter-point reduction would "free up" another $6.25 billion for American consumers.

Source
How the failure of subprime mortgages hurts the overall economy
John Gallagher
Detroit Free Press, January 6, 2008
http://www.freep.com/apps/pbcs.dll/article?AID=/20080106/BUSINESS06/801060585/1002/BUSINESS