There was big news in the economy this afternoon. If you haven’t heard yet, the Board of Governors of the Federal Reserve System unanimously approved a 50-basis-point (1 basis point is 0.01%) decrease in the discount rate this afternoon. They also decided today to lower its target for the federal funds rate 50 basis points.

This is big news for the economy and the effect could be almost instantly seen by the fact that the Dow Jones Industrial Average reacted by surging 335 points (its biggest one-day point jump in nearly five years) and most of that change was in the last portion of the trading day.

However, most people will wonder what this means to them. This post is an attempt to explain that. The discount rate is the interest rate charged to commercial banks and other depository institutions on the loans they receive from their regional Federal Reserve Bank’s lending facility. It does not have a direct effect on consumers because the rare practice applies only to banks that are having short-term financial difficulties.

On the other hand, the federal funds rate is the benchmark overnight lending rate between banks and it can influence many consumer credit rates because it determines how much banks charge each other when they borrow money.

Notice I said that it can influence the rates that you deal with on a regular basis. This is because the federal funds rate only moves consumer rates indirectly. It raises or lowers borrowing costs for banks. If it goes higher, the cost is passed on to consumers. If it goes lower, the savings is either passed to the consumer or pocketed by the bank. Due to this, it may or may not affect the interest rates we see as consumers.

To show the similarities of these two rates, banks charge each other the federal funds rate. When a bank borrows from the Federal Reserve, they are charged the discount rate. Both of these rates impact the prime rate (the rate that your loans are based on) but not directly.

As a consumer, you may see the lowering of some of your interest rates due to this, but it is not guaranteed. For further reading, see the links below.

Active Rain - FED DISCOUNT WINDOW CUT…WHAT DOES IT MEAN FOR YOU?

Kiplinger - Federal Reserve Rate Cut: What Does It Mean?

About.com: Investing For Beginners – What is the Feds Fund Rate?

Rate Empire – Federal Reserve Setting Rates