Federal reserve rate cuts impact fixed deposit rates because the cost of obtaining capital becomes cheaper for banks. Since the Federal Reserve Bank lends large amounts of money to banks, when they lower interest rates it becomes more cost effective for those banks to lower interest rates on consumer deposits since the bank's and/or financial institution's demand for money declines.
Deposits made to banks from consumers and/or non-financial businesses are fixed or variable. In the case of fixed deposit items such as certificates of deposit, money market funds, savings accounts and club accounts, changes in rates set by the Federal Reserve impact the interest yielded from such accounts.
How the Federal Reserve Bank changes interest rates
Generally, when the economy is growing well, interest rates rise making the acquisition of capital more expensive. The reason for this is the growing economy makes use of more capital than a recessionary economy hence the increase in demand. Since cost and demand are related via the economic principle of supply and demand, cost of deposits rises due to a greater need for capital in the economy. Inversely, when the economy is not growing fast or experiencing negative growth, the Federal reserve often makes it cheaper for financial institutions to acquire capital. It does this to help stimulate economic growth and does so through a decision making process carried out via the Federal Reserve board.
Different types of Federal Reserve interest rates
The federal reserve has a number of different lending rates including 1) the prime rate, 2) the federal reserve overnight interest rate, 3) Federal funds rate 4) Money Market Investor Funding Facility (MMIFF), and the indirect cost of financing T-Bills i.e. U.S. Government Treasury notes. According to bankrate.com, when the federal reserve funds prime rate is adjusted, the affect on the market includes changes to a wide range of accounts because the amount it costs financial institutions to borrow is affected as mentioned above. Changes to these Federal reserve derived lending rates impact fixed deposit rates.
Although the secondary market for T-bills can affect interest rates on these high denomination securities, the affect on bank borrowing costs via fixed deposit rates is not as direct as the over federal funds rate i.e. the cost of inter-bank borrowing. This is so as not all U.S. banks necessarily capitalize via re-lending borrowed funds to the Government via Treasury securities. However, if market conditions and the economy are weak, and the prime rate is lower than the T-bill rate, banks and financial institutions could yield a safe profit via borrowing using the prime rate and lending using the T-bill rate.
Affect of interest rate changes on fixed deposit rates
Since the Federal reserve bank, although a privately owned institution, is in effect a national central bank, it has significant influence on the availability of capital within the United States' financial markets, and financial system. Simply put, when the banks' bank lends at a lower cost, banks don't need to borrow from consumers quite so much.
Three sources of capital for financial institutions are 1) the Federal Reserve bank 2) other banks and/or corporations and 3) the consumer market. Banks and financial institutions are businesses and therefore often borrow at the lowest cost and lend at higher costs. Thus, when the fed lowers interest rates, whether they be the prime, federal funds rate or other sources of fed influence such as via MMIFF financing, the cost to banks becomes lower with the affect of a lower interest rate on consumer accounts.
Summary
To summarize, the Federal Reserve bank is a privately owned, national central bank for the United States of America. Such being the case, the federal reserve bank lends money in large amounts and sets important interest rates for its funds and that of U.S. banks. When rates are changed, this affects the cost of capitalization for financial institutions such as banks, credit unions, savings and loans institutions such as mortgage lenders. (www.federalreserveeducation.org)
The Federal Reserve bank arrive at interest rate changes through the Federal Reserve Board and change rates with the goals of facilitation economic functionality. When rates are changed, the borrowing costs of financial institutions changes making availability of capital greater, less or the same as previous rates. These changes affect the cost of liquidity for financial institutions, and therefore affect fixed deposit rates because financial instruments funded through fixed deposit rates are also a source of capital for financial institutions.
Sources:
1. http://www.federalreserveeducation.org/fed101/policy/basics.htm
2. http://www.federalreserveeducation.org/fed101/services/index.cfm
3. http://www.bankrate.com/brm/ratewatch/leading-rates.asp
4. http://en.wikipedia.org/wiki/Treasury_security
5. http://www.investorwords.com/3837/prime_rate.html
6. http://www.federalreserve.gov/monetarypolicy/mmiff.htm
7. http://tinyurl.com/4ev3sw8
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