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How Fed's Rate Hikes Ripple Out Into the Marketplace

IT does not take long for the Federal Reserve's desire for higher interest rates to become reality. Here's one way the nation's central bank makes it happen:

The Federal Reserve Board almost always enters the money markets - that is, the daily trading in short-term Treasury securities - at 11:30 a.m. At that time, the government can remove cash from the markets by temporarily selling securities to various government dealers. The dealers buy the securities and tender their cash to the Fed. This drains money from the banking system.

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Former Fed employees say the government usually only sells a few billion dollars in securities before the money markets get the idea that the Fed wants to raise interest rates.

``It is not the amount, just the signal they send,'' says Paul Kasriel, an economist with Northern Trust Company in Chicago and a former Fed employee.

The Fed also can use seasonal factors to move interest rates higher. For example, at this time of year, there is a higher banking demand for cash since a large number of Americans take vacations and draw extra money for their trips. If the Fed does not inject new cash into the banking system, short-term interest rates will rise to reflect this demand - likely by one-fourth of a percentage point.

However, if the Fed wants to make a point with the bond market, it will drain reserves of cash as well. This could raise interest rates by one-half of a percentage point.

The Fed's actions shift quickly to the most short-term interest rate area, called Federal Funds, which is the money commercial banks borrow from each other overnight to meet the reserve requirements imposed by the Fed.

As news of the Fed's action spreads, however, banks and brokerage houses begin bidding more aggressively for other short-term funds, such as three-month Treasury bills, and commercial paper, the short-term securities issued by companies.

Quickly, the ripple effect spreads to other areas that use short-term interest rates as part of a base formula. Thus, the higher rates spread to adjustable-rate mortgages, home equity loans, credit cards, and personal loans. It also can bump up the prime rate, the interest banks charge on loans to good customers. At the same time, banks offer savers slightly better interest on short-term certificates of deposit.

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