About an hour before the U.S. markets’ opening bell, the Federal Reserve dropped the Overnight Discount Rate by .5%. The markets initially reacted like the Fed was passing out free money, moving the DJIA up over 300 points briefly. (as of 9:30 CST, the market is still up abour 150 points).

First, what actually is the Overnight Discount Rate? The Federal Reserve’s Discount Rate is ,..

… the rate that an eligible depository institution (such as a bank) is charged to borrow short term funds directly from the central bank through the discount window. This is also known as the base rate, repo rate and/or primary rate

What this actually means is that the Fed is lowering the interest rate it charges banks for short-term loans, which means banks can borrow money at a lower rate, and (some of) that rate can be passed on to the bank’s customers. Specifically, it means that the banks that are loaning funds to the companies in the Subprime mortgage business, have more funds to loan. The Subprime mortgage companies get more operating capital, and can continue to make loans and operate their business.

This is a positive influence to the market. As an example, Countrywide Mortgage, one of the largest mortgage companies in the U.S. just received $11.5 billion in additional loans to continue operating and making loans. People that have investments in Countrywide can be more assured that Countrywide won’t lose value and/or declare bankruptcy, and will be more likely to hold their investments, rather than get rid of them.

The Effects?

Short Term: An added liquidity is guaranteed to the market, working to calm the fears of more bankruptcies by Subprime mortgage companies, and the fears of a tightening of credit by the banks. Businesses can ‘relax’ some of the emergency actions the were contemplating (cut-back in business development, layoffs, etc) and individual investors will have more confidence that their investments will stop dropping in value.

Long Term: Possibly could counteract the current market pessimistic opinions. It may trigger an increase in inflation because of the influx of money, but this (IMHO) is unlikely.

Overall: This is a reaction by the Fed to the recent drops in the market in an attempt to stabilize the situation. There are rumors going around that the Fed may also lower the Federal Funds Rate as well, which influences the Prime Rate.

Hopefully this will calm the market down and get everyone to stop panicking and selling like crazy.