Fed cuts rates to spur post-disaster spending

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Imagine a poster picturing Alan Greenspan dressed in a red, white and blue top hat and a star-spangled vest, sternly pointing a gaunt finger straight at you. The caption below reads: “I Want YOU — To Spend.”

That’s the message that Greenspan and the Fed have delivered with their unscheduled but unsurprising rate cut Sept. 17. The Fed’s Open Market Committee cut the federal funds rate by half a percentage point, to 3 percent. In related action, the Fed’s Board of Governors cut the discount rate by half a percentage point to 2.5 percent.

“Even before the tragic events of last week, employment, production, and business spending remained weak, and last week’s events have the potential to damp spending further,” the Federal Open Market Committee said in announcing the rate cut.

And the Fed doesn’t want Americans to “damp spending” — to stop buying stuff. The Fed is encouraging us to keep spending. Consumer spending constitutes two-thirds of the economy, and the last thing the Fed wants is for us to sit in front of the TV all day, watching the news and putting off those trips to the mall and the car lot.

So the committee cut the federal funds rate. Expect to see a drop Tuesday in the prime rate published by the Wall Street Journal. Some, but not all, interest rates will follow: those for new car loans, home equity lines of credit, shorter-term home equity loans and some adjustable-rate mortgages should fall in the coming days and weeks.

It’s a different story for fixed-rate mortgages, used-car loans and most credit cards. These types of loans either don’t closely follow the rates that the Fed controls, or they respond more readily to other factors. For example, many credit cards have a minimum interest rate, below which they won’t fall. Lots of credit cards reached their minimum rate earlier this year.

This brings up a question: If credit card rates don’t fall, will Americans really boost their spending much? Or will people sit tight, pay down their balances, and wait until the holiday shopping season to decide whether to open their wallets? The Fed’s rate cut might not have much of an effect on consumer spending unless prominent politicans exhort us to spend as a patriotic duty.

William Ford, a professor of finance at Middle Tennessee State University, says “cutting the rates is not an inconsequential thing.” Not all credit cards have floors, he says, and when you look at the overall effect nationwide, credit card interest rates will be lower. This is happening, he says, while people are getting their tax refund checks.

This was the eighth rate cut this year. On Jan. 1, the federal funds rate stood at 6.5 percent. Now it’s at 3 percent, and the Fed signaled Monday that it stands ready to go even lower. It said that “the risks are weighted mainly toward conditions that may generate economic weakness.”

On the other hand, the Fed said that “the long-term prospects for productivity growth and the economy remain favorable and should become evident once the unusual forces restraining demand abate.”

In Fed-ese, the phrase “unusual forces restraining demand” seems to mean television viewing.

“Exactly,” Ford says. “If you go back to the Gulf War, for 100 days, every day, TV viewing went through the roof and the economy collapsed. We went into recession.”

He says the Fed worries that any retaliation would turn into a “CNN event,” gluing Americans to their TV screens “instead of going out to the ballgame or going to the mall to shop or getting on an airplane and going somewhere.”

Observers including Ford expect to see an increase in mortgage refinancing because mortgage rates seem headed to lows last seen in 1998. Long-term mortgage rates are tied closely to 10-year Treasury bonds, and the yields on those bonds have headed downward in the past few days.

The open market committee’s next scheduled meeting is Oct. 2. Other meetings are set for Nov. 6 and Dec. 11. The market in Fed futures reflects a belief that the Fed will reduce rates by another half a percentage point, probably by year’s end.

The federal funds rate was 3 percent from July 1992 until May 1994. It has not been lower than 3 percent in the past 30 years.

The Fed also said that it will continue to pour money into the banking system to ease people’s jitters worldwide. It said that the federal funds rate might actually dip below 3 percent occasionally “in these unusual circumstances.” Don’t expect those dips to affect the prime rate, though.

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: In other words, it wants banks to borrow from one another at the federal funds rate before borrowing from the Federal Reserve at the lower discount rate.

— Posted: Sept. 17, 2001