Federal Reserve makes emergency rate cut

The Federal Reserve, informally the Fed, responding to fears about a possible United States recession, makes a surprising move to cut its overnight discount rate between banks to 3.5 percent, from 4.25 percent, International Herald Tribune (01/22, Grynbaum and Holusha) reported. This is a good example of "monetary policy" as a tool for the government to manage the economy.

As the central banking system of the United States, the Fed is composed of (1) the presidentially-appointed Board of Governors of the Federal Reserve System; (2) the Federal Open Market Committee; (3) 12 regional Federal Reserve Banks located in major cities throughout the nation; (4) numerous private U.S. member banks, which subscribe to required amounts of non-transferable stock in their regional Federal Reserve Banks; and (5) various advisory councils. Currently, Ben Bernanke serves as the Chairman of the Board of Governors of the Federal Reserve System.

The Federal Reserve is in charge of monetary policy, which influences the availability of cash and credit in the market to stabilize the growth of national economy. To achieve it goals, the Fed relies on three main tools:

• open market operations - purchases and sales of U.S. Treasury and federal agency securities to control the amount of cash circulation;
  
• discount rate - the interest rate charged to commercial banks when they borrow money from regional Federal Reserve Banks;
  
• reserve requirements - the amount of funds that a bank must hold in reserve against specified deposit liabilities

The discount rate is not market interest rates which vary for different banks and to different borrowers. However, functioning like "the bank of banks," the Fed sets a discount rate that directly affects market interest rates. Therefore, it is often called as the "benchmark rate." The 0.75 emergency rate cut was unusual both in its scale and its timing: In recent years, the Fed's rate changes were almost always in increments of one-quarter or one-half point. It was the biggest single cut since October 1984.

Note that monetary policy should be contrasted with fiscal policy, which refers to government borrowing, spending and taxation -- According to Keynesian economic theories, running a fiscal deficit and increasing government debt can stimulate economic activity, while running a fiscal surplus with lower level of spending can prevent economic overheating. Nevertheless, fiscal policy has been less effective in recent years, in part because the federal government is almost always running deficits.