For the second time in just over a week, the Federal Reserve has lowered short-term interest rates. This time, the move was widely expected.
The central bank’s Federal Open Market Committee reduced the target federal funds rate half a percentage point, to 3 percent. This affects consumers because the prime rate will fall half a point, too, to 6 percent. Variable-rate credit cards and home equity lines of credit are linked to the prime rate, so they will fall another half-point over the next couple of billing cycles. The Fed’s rate cut is designed to get consumers borrowing and spending again.
“Financial markets remain under considerable stress, and credit has tightened further for some businesses and households. Moreover, recent information indicates a deepening of the housing contraction as well as some softening in labor markets,” the Fed explained, adding that the rate-setting committee expects inflation to settle down in the next few quarters.
The Fed went on to say that the combined rate cuts — totaling 2.25 percent since September — should promote moderate growth. “However, downside risks to growth remain.”
The vote wasn’t unanimous. Richard W. Fisher, of the Federal Reserve Bank of Dallas, voted against a rate cut. The central bank also reduced the discount rate by a half-point. The Fed charges the discount rate on direct loans to member banks.
The rate-setting committee has eight scheduled meetings a year. On Jan. 22, the committee took the unusual step of cutting short-term rates between scheduled meetings. That day, the Fed reduced the federal funds rate by three-quarters of a point, to 3.5 percent. It explained that it took the move “in view of a weakening of the economic outlook and increasing downside risks to growth.” That was a clear statement that the Fed is in recession-fighting mode. Today’s rate cut confirms that.
Recession versus inflation
Everyone recognizes that the Fed risks starting or exacerbating a recession if it keeps rates too high. But the central bank risks igniting inflation if it sends rates too low. The rate-setting committee has chosen which misstep it would rather make: inviting inflation.
“The main concern they’ve got right now is the economy, period, and they don’t want to take a recession,” says John Burford, vice president and investment portfolio manager for The International Bank of Miami. “In order to avoid that, they’re willing to take some inflation risk.”
That isn’t to say that he agrees with the rate cut. “Sad to say,” Burford said before the rate cut was announced, “they’ve built up a pretty good expectation in the markets that they’re going to do something.” Leaving rates alone would have been a sell-off in the stock and bond markets, and that’s not what the Fed wanted.
Richard DeKaser, chief economist for National City Corp., says the Fed’s recent actions are difficult to interpret. “For the longest time, we had a very reluctant Fed that was gradualist in its approach and really moving only in reaction to very persuasive evidence that rate cuts were necessary,” DeKaser says.
Last week’s big, unscheduled rate cut was not gradualist, and there are still arguments to be made that more rate cuts aren’t necessary. The Fed has slashed the federal funds rate from 5.25 percent to 3 percent since September, and it usually takes six to 12 months for the effects of rate reductions to show up in the economy, DeKaser says: “The pipeline of monetary stimulus is still pretty full.”
Mortgage rates don’t respond right away
Long-term rates, such as those for mortgages, don’t respond directly to the Fed’s short-term rate moves. Sometimes, mortgage rates move in the opposite direction when the Fed reduces the federal funds rate. But more often than not, mortgage rates eventually follow the Fed’s lead. That might be one of the motivations of the central bank, DeKaser says — “to help the housing market by lowering the refinance rate on many resetting mortgages. That makes it easier for people confronting resets, which we know are rampant right now, to achieve more affordable rates.”
The federal funds rate is the target interest rate for banks borrowing reserves among themselves. The discount rate is the interest rate that the Fed charges banks to borrow reserves from the Federal Reserve. The Fed wants to be the lender of last resort: It wants banks to borrow from one another at the federal funds rate before borrowing from the Federal Reserve at the higher discount rate.