We like to think that when we deposit a dollar at the bank, it goes into a big vault and we can pull out that same dollar at any time. But that¿s not how the U.S. banking system works. Banks take that money and invest it to make money themselves, so cash gets spread around. This, naturally, leads to a big risk: What happens if those investments go sour? Well, you¿d be out of luck. You can¿t get your dollar back.

The Federal Reserve doesn¿t like that scenario, so it prohibits banks from putting all the cash it has on deposit on the line. In fact, the Fed forces banks to keep a portion of their assets at the Federal Reserve itself, to make sure that some of your assets won¿t get squandered if the bank¿s bets go south. These are called ¿reserves,¿ (hence, Federal Reserve. Got it? Good), and usually amount to 10% of the total cash kept in checking accounts.

These reserves are never exactly 10%, and banks like to keep a little extra in reserve ¿ not, as you might think, to make you more comfortable that they¿re in good financial shape, but rather so they can take that excess and lend it to other banks and make money off it. (They¿re banks, they can¿t help themselves.) The rate at which they make these loans is called the Federal Funds rate, which is set by the Federal Reserve¿s Federal Open Market Committee.

When you hear people chattering about how the Fed cut or hiked interest rates, this is what they¿re talking about: the interest rate banks can charge for lending money from their reserves. This begs the question: If these are essentially loans between banks, why is the Fed Funds rate so important for the rest of the economy?

Well, simply put, because loans make the financial world go round. Bank A lends Bank B $10,000 at a Fed Funds rate of 5%. Bank B then lends out $10,000 to a small business at 7%. The small business then takes that money and expands the business and hires new workers. Now someone is employed, Bank B has made interest off the loan, and Bank A is the richer for making it all happen. It¿s perhaps overly simplistic, but you get the idea. When you want the economy to thrive, you make lending cheaper.

Of course, sometimes you don¿t want the economy to thrive. In fact, you might want it to cool down, mostly to avoid money flooding the system and causing inflation. In that case, the Fed raises interest rates, making it difficult to lend or borrow.

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Friday, August 08, 2008

Oil Tumbles as the Dollar Strengthens

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Associated Press

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Oil prices resumed their descent Friday, dropping briefly below $116 a barrel as a huge jump in the U.S. dollar and expectations of slowing global demand offset supply concerns over a sabotaged pipeline in Turkey.

Light, sweet crude for September delivery slumped $3.84 to $116.18 a barrel in late morning trading on the New York Mercantile Exchange, after dipping as low as $115.75. Prices for gasoline, heating oil and natural gas also dropped. In London, September Brent crude plunged $4.00 to $113.86 a barrel on the ICE Futures exchange.

Many analysts have pointed to the $117-a-barrel mark for crude oil as technically significant -- a move below this level suggests, they say, that oil's recent slide is more than a brief pullback. Crude peaked at $147.27 on July 11.

"You have to remember that this market has baffled anyone who's used fundamentals or charts. But if you're a chartist, today is the death knell for the possibility of new highs in the market place," said Tom Kloza, publisher and chief oil analyst of the Oil Price Information Service in Wall, New Jersey.

With the dollar launching a massive rebound against the euro and yen after the European Central Bank and the Bank of England both left their benchmark interest rates unchanged, energy traders found reason to sell -- especially since the ECB indicated that there probably wouldn't be any more rate hikes to come.

Higher interest rates make a country's currency more attractive to invest in.

By early U.S. trading, the euro dropped to $1.5042 against the dollar, while the dollar rose to 110.16 yen. The British pound tumbled to $1.9155, reaching its lowest point since November 2006.

The weak dollar had been boosting oil prices earlier this year, because dollar-denominated commodities are often used as hedges against inflation and a falling U.S. currency.

Furthermore, the central banks' actions bolstered the growing belief in the energy markets that economies around the world are slowing alongside the United States, dampening global demand for crude oil products.

"The biggest driving factor now to the downside is the fact that the U.S. economy has a lot of company right now in terms of weakening economic growth," Cordier said, pointing to both China and India.

Oil had risen $1.14 Thursday to close at $120.02 a barrel after Turkey's state-run news agency Anatolia said the pipeline, attacked by the separatist group Kurdistan Workers' Party, could be shut down for up to 15 days. The pipeline can pump slightly more than 1 million barrels of crude oil per day, or more than 1% of the world's daily crude output.

In Turkey, pipeline shareholder BP PLC and other oil companies declared what's called a force majeure after the pipeline attack, freeing them of contractual obligations to deliver crude.

"While that is significant, the 'strength' this event supposedly created yesterday was rather insignificant," wrote trader and analyst Stephen Schork in his daily Schork Report, referring to oil's fairly modest price bounce on Thursday.

Nymex front-month crude futures are down about 18% from their record high. They are still up, however, more than 60% from a year ago.

Earlier this year, Americans were paying about $1.65 billion a day for gasoline at the peak of prices and demand, Kloza said. The country appears to be headed for below $1.5 billion a day now that prices are coming down and demand is slowing, he said, but he pointed out that that's still three times what Americans were paying in 2002.

Heating oil futures slipped by nearly 10 cents to $3.1352 a gallon on the Nymex, where gasoline prices fell by over 8 cents to $2.9174 a gallon. Natural gas futures fell by more than 34 cents to $8.226 per 1,000 cubic feet.