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The Short Answer

How Do Fed Rate Cuts Impact Your Portfolio?

Here's what recent Fed actions may mean for you.

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In the summer of 1992, as a young student in economic history, I studied comparative economics at Georgetown University in Washington, D.C., and interned at a free-trade lobby. During my course of study, I had the opportunity to visit the Federal Reserve with a group of students to meet with a board governor and be briefed on the workings of the central bank of the United States. Of course, being young, I was more excited by the fact that I sat in Alan Greenspan's chair (nameplate affixed) at the Fed's conference room table than I was with what I was supposed to be learning. In any case, unlike impetuous students, investors need to be more concerned with the policy changes emerging from this room than with its personalities.

While many factors, such as inflation expectations and supply and demand, will impact interest rates, it's important to understand the Fed's role as well. The Fed's Federal Open Market Committee, currently chaired by Ben Bernake, regulates short-term interest rates with the aim of promoting economic growth (and thus employment) and stable prices (or modest inflation). To achieve those goals, the FOMC has three levers that it can pull: open market operations, the discount rate, and setting bank reserve requirements. Recently, investors have witnessed open market operations, in a series of fed-funds rate cuts (most recently a dramatic 0.75% drop to 3.5% on Jan. 22), as well as cuts to the discount rate, designed to stabilize uncertain bond markets and keep the economy from slipping into recession.

Each of these tools aids the Fed in regulating money supply and thus in either stimulating or reining in the economy. The biggest of the three is open market operations. The Fed can't declare interest rates by fiat, but it uses open market operations to get to the rate level it wants. If it wanted to lower rates, for instance, the Fed would increase the money supply. To do so, it would buy government bonds on the open market (this is why it is called open market operations), putting cash into the economy. When the Fed wants to raise rates, it shrinks the money supply by selling government bonds. The most meaningful interest rate that the Fed controls is the fed-funds rate, the short-term rate at which banks lend to each other. That rate is usually the tune by which the rest of the economy sings. If the fed-funds rate goes up, mortgage and credit card rates tend to do so as well--and vice versa.

Lawrence Jones does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.

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