There has been much talk about Federal Reserve policy and rates this past week and about their value and impact on the stock and bond markets. This article is intended to clarify and illustrate some of the terms and current conditions.Last week William Poole, President of the St. Louis Federal reserved said that the subprime mortgage situation doesn’t threaten U.S. economic growth, and that only a “calamity” would justify change at this time. He saw no data suggesting any rate cuts were needed. That sent alarm bells around the markets and earned him the title “Calamity” Bill.Jan Hatzius, Chief U.S. economist at Goldman Sachs, said: “We are rapidly moving toward a situation where they [the Fed] maybe have to choose between sticking with their previous inclination [to] wait until their Sept. 18 meeting and risking serious damage to the economy [by delaying action].”A few days later the Fed cut the “Discount Rate” from 6.25% to 5.75%, but not the “Fed Funds Rate” which it kept at 5.25%. The markets were greatly encouraged and rallied. The Prime Rate has not changed, and remains at 8.25%.So what the heck are these rates and what to they do?Fed Funds Rate:The Fed Funds Rate is the interest rate at which U.S. banks lend to each other their excess reserves held on deposit at the U.S. Federal Reserve.Discount Rate:The Discount Rate is the rate at which U.S. banks can borrow from the U.S. Federal Reserve.Prime Rate:The Prime Interest Rate is the interest rate charged by banks to their most creditworthy customers (usually business customers). The rate is almost always the same among major banks. Adjustments to the prime lending rate are typically made by banks at the same time.The chart below shows recent monthly figures for the three rates, with a longer view of the Fed Funds Rate.

The next chart shows the difference (spread) between the Discount Rate and the Fed Funds Rate.

The first thing you notice is the generally parallel movement in the rates. The second thing you notice is that the cost to banks for borrowing from the Fed has dropped, while the rate they earn loaning to each other and the rate they charge their customers has not dropped. That means they make more money when they loan today than they did last week. That means banks are somewhat more likely to lend and that the economy will be somewhat more liquid. That presumably will help reduce investor worries in the bond and stock markets over the liquidity aspects of the current debt crisis.The technique worked last week. The big question is whether it will work this week or longer.Four bellweather stocks for the question are VTI (Vanguard U.S. Total Stock Market) and SPY (S&P 500), AGG (Lehman Aggregate Bond Market) and IEF (Lehman Intermediate Treasuries).Disclosure: author does not own any secuity listed[tags] federal reserve, stock market, interest rate, loans, lending, housing, the fed [/tags]