The Federal Reserve Mandate

• The Federal Reserve has a federal mandate to "promote...the goals of maximum employment, stable price, and moderate long-term interest rates." The Federal Reserve Board (the Fed) meets periodically to set target rates for federal funds that will accomplish these goals. Institutions that have funds on deposit with the federal reserve (depository institutions) will then charge other depository institutions a correspondingly higher interest rate on overnight loans.
  
  

Influence Of The Fed Funds Rate

• The Fed Funds Rate widely influences the cost of funds. The Prime Rate, the loan rate for large corporations borrowing wholesale money, usually averages around three percent higher than the Fed Funds Rate. The 30 year fixed mortgage usually settles about halfway between the Fed Funds Rate and the Prime Rate. When you, a small business person, want to borrow $100,000 from your local bank to expand your Widget business, you'll pay some premium--often from one to three percent--over the Prime Rate for your loan.
  
  

The Cost Of Money

• When the cost of money rises, financial activity slows down. If you know that you can lower unit costs by buying a better Widget-making machine, you have to compare the benefit with the cost--not only the price you will pay for the Widget machine, but the cost of the money you borrow from your bank to pay for it. As interest rates rise, at some point you will determine that because of the interest expense, the benefit no longer justifies the cost. You do not buy the new Widget maker. As interest rates rise, more and more businesses make the decision not to borrow money for capital expenditures. The economy slows down.
  
  

Irrational Exuberance

• When they meet to determine the Fed Funds Rate, the board members take into account the stock-market trend. In December, 1996, Alan Greenspan remarked that at times "irrational exuberance" can unduly escalate asset values to a point where the subsequent market collapse can "threaten to impair the real economy, its production, jobs and price stability"--a near paraphrase of the Fed's mandate to moderate excessive market swings. At such times, the Fed will begin raising interest rates to prevent a market bubble, and to slow down an over-heating economy..
  
  

What Happens to CD Rates

• When the Fed raises its rates, your bank will then charge customers more for personal loans, business loans and mortgages. Consequently, they will offer you a higher rate on CDs. A similar sequence of events occurs as the market falls and the country begins to slip into recession. The Fed lowers rates to support the market and stimulate the economy. Your bank then charges less for loans, and will pay a lower interest on CDs. Of course, the interest rate on standardl CDs does not change during the life of the CD, and so CDs that are already issued will not be affected by rate changes.