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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.
Home / Personal Finance / Lifestyle & Money / Consumer & Debt
Monday, April 07, 2008
Consumer Borrowing Drops in February
Associated Press
WASHINGTON--Consumers, battered by a credit crunch and prolonged housing slump, significantly slowed their pace of borrowing in February.
The
Federal Reserve reported Monday that consumer borrowing rose at an annual rate of 2.4% in February, just half of the 4.9%
increase in January.
The slowdown reflected much weaker demand for auto loans and other type of non-revolving credit,
which rose at a rate of 0.4% in February, much lower than the 3.6% growth rate in January. Credit card debt rose at a 5.9%
rate.
Consumers have been moving to put more of their purchases on their credit cards as banks have tightened up on
lending standards for home equity loans in response to the deepening credit crisis. The price of homes has fallen sharply
in many parts of the country.
The 2.4% overall rate of increase was the slowest since debt growth had slowed to a 1%
rate in December.
The overall increase in credit of $5.16 billion, which was slightly below expectations, pushed total
consumer credit to a record $2.539 trillion.
The Fed's measure of consumer borrowing does not include any debt secured
by real estate such as mortgages or home equity loans.
The economy has slowed dramatically in recent months under the
impact of a slump in housing, a severe credit crisis that hit in August and rising unemployment. The government reported Friday
that unemployment jumped to 5.1% in March as businesses slashed another 80,000 jobs.
While many economists believe
the country has slipped into a recession, the Bush administration says that growth should revive starting this summer when
130 million households start spending their economic stimulus checks.
Meeting Monday at the White House with owners
of small and medium-sized businesses, President Bush said the economy was going through a "rough time" but he was confident
things would turn around. He urged lawmakers contemplating passage of a second economic stimulus measure to allow more time
for the first $168 billion package to work.
"Give this one a chance to work," Bush said during the meeting with business
executives including those in the orchard, meat packing and large equipment industries.
He said experts were telling
him that the stimulus package would boost overall economic growth by between 1% to 1.5% later this year.
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