Bankers nationwide have been heartened by the Fed’s two recent reductions in the federal funds rate — the rate at which banks lend excess reserves to one another — by 50 basis points each time.

Almost all bankers understand the effect of the Federal Reserve’s easing of credit. But very few understand how, after the announcement of a rate policy change, the Fed’s stated goal is achieved.

What did the Fed really do? How can the Fed ensure it will achieve a 50-basis-point reduction in the funds rate?

The answer is that it can’t, not directly. Rates are set by the marketplace. All the Fed can do is enter the financial market to buy Treasury securities, supplying the sellers of these securities new deposit money.

If a bank sells the securities, it gets the cash immediately, reducing its need for funds to satisfy reserve requirements. If a nonbank sells them, it gets the Fed’s payment and deposits it in its bank.

So the banking system gets a precisely calibrated infusion of funds either way.

This is called adding reserves to the banking system because it reduces the need of banks to borrow to meet reserve requirements.

The Fed then calls around to gauge the impact of its purchases. If the expansion of reserves reduces demand sufficiently to let buyers of federal funds get them for 50 basis points less than before, the Fed stops its purchases. If the decline in the funds rate is less than 50 basis points, the central bank keeps buying securities until the 50-basis-point decline is achieved.

It is that simple.

Compare it to someone hitting you on the nose and asking, “Am I hurting you?” If you answer “only slightly,” he hits you harder. If you say “ouch,” he stops.

What is seldom grasped by the general public is that interest rates are like all other prices — they are set by the market, by the buyers and sellers of the commodity or security. All the central bank can do is alter conditions in the marketplace.

The same is true for the international value of a currency. The Fed cannot determine the value of the dollar; this is set by foreign exchange dealers. So if it wants to strengthen the greenback, it must buy dollars, paying for them with other currencies, until the Fed-initiated increase in demand for dollars causes dealers to raise the price for them.

There is a similar lack of understanding about the discount rate — the rate the Fed charges banks when they borrow from it.

The discount rate is always much lower than the rates banks charge on loans. So one might assume that banks could make a killing by borrowing from the Fed at, say, 5% and then lending the money out at, for example, 18% on consumer loans.

But only a small number of banks actually borrow from the Fed. Such borrowing is a privilege, not a right. Banks that borrow must explain to the Fed why they are in dire enough straits to have to do so.

It is like borrowing from your mother-in-law — who immediately starts hounding you to repay.

Very few banks ever use the Fed’s discount window, and most readers of this newspaper work for banks that have not borrowed for years, if ever.

What, then, is the significance of the discount rate? It is similar to the pronouncements of Fed Chairman Alan Greenspan. The discount rate is a signal, just as Mr. Greenspan’s announcements are signals — a lower discount rate means credit will soon ease and a higher one means it will tighten.

The Fed does not set interest rates. What it does is influence them by altering the environment in which all institutions that lend and borrow money must operate.

Mr. Nadler, an American Banker contributing editor, is a professor of finance at Rutgers University Graduate School of Management in Newark, NJ.

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