For the first time in more than four years, the Federal Reserve has made it cheaper to borrow, and by an unexpectedly big margin.

Federal funds rate
 

The central bank’s rate-setting committee lowered the target for the federal funds rate by half a percentage point, to 4.75 percent. The prime rate will fall to 7.75 percent. Consumer interest rates based on the prime rate — mainly home equity lines of credit and most variable-rate credit cards — will fall a half-point in coming weeks.

Yields on certificates of deposit are likely to fall, too — especially on shorter-term CDs — even though they’re not tied directly to the prime rate. As for mortgages: Don’t count on mortgage rates to fall. They might, but they might not.

Everyone had expected a Fed rate cut, from investors and economists to teachers and car valets. The principal uncertainty had been about the size of the upcoming cut — would it be a quarter of a percentage point, or half a point?

Most were expecting a smaller, quarter-point cut. The Fed sprung the surprise half-point decrease with this explanation:

“Economic growth was moderate during the first half of the year, but the tightening of credit conditions has the potential to intensify the housing correction and to restrain economic growth more generally. Today’s action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time.”

The committee added that inflation has been dropping, but that “some inflation risks remain.”

This rate cut is intended to undo some of the damage caused by the housing bubble and the resulting credit crashes. The idea is to get people and businesses to buy on credit — just not so recklessly this time.

Some economists and analysts worry that the Fed behaved recklessly with this half-point cut. A quarter-point decrease would have been preferable, they say.

“It would certainly be inflationary,” says Anthony Liuzzo, a professor of business and economics at Wilkes University in Wilkes-Barre, Pa., speaking before the Fed’s announcement. “It’s kind of like eating sugar to get energy. It will strengthen you in the short term, but in the long term will be unhealthful.”

Each year around this time, Liuzzo prepares an estimate of upcoming holiday spending. He forecasts a 3.5 percent increase in holiday spending this year, compared to a 4.4 percent rise last year. The forecast is subject to revision if an unexpected event occurs.

Why the Fed cut
Jim Baird, chief investment strategist for Plante Moran Financial Advisors of Southfield, Mich., believes two factors were behind this rate cut. “First, I would say that the market expects them to do something,” he says. In other words, the Fed had to meet investors’ expectations. Wall Street expected a rate cut, and would have reacted badly in the absence of one.

“On a more practical note, they may very well need to cut, in order to avoid further softening of the economy,” Baird adds.

Investors wanted a half-point reduction. Many economists would have preferred a quarter-point cut for fear that a bigger decrease would look panicky. Now the Fed has to spin the rate cut in a way that will make the central bankers look calm.

“From a psychological standpoint, they might want to send a message to the market that they’re concerned about developments and may want to take a more significant step than just cutting by a quarter-point,” Baird says.

There’s a risk that further down the road, the data will suggest that a rate cut was unnecessary. “But I don’t think that scenario is very likely at this point,” Baird says, because retail sales were weaker than expected in August. “That is evidence that the consumer is beginning to pull back a little bit, and that is not a positive sign for economic growth.”

Will the cut affect mortgages?
The biggest economic story of the year concerns housing: Home sales and average house prices have fallen nationwide, and it’s harder to get jumbo and subprime mortgages. Lower mortgage rates might ease those troubles, but a Fed rate cut doesn’t necessarily spell lower fixed-rate mortgages.

From Jan. 3, 2001, to June 25, 2003, the Federal Reserve cut the federal funds rate 13 times. When you look at what happened to the 30-year, fixed-rate mortgage in the month after each cut, here’s what you find: Mortgage rates fell eight times and rose five times.

“There is a huge amount of misperception among borrowers that if the Fed reduces the rate half a point, my mortgage rates will go down,” says Dan Dowling, president of United Mortgage Capital Corp., in Altamonte Springs, Fla.

Long-term mortgage rates go up and down mostly in response to investors’ expectations of inflation.

This is the Federal Reserve’s first rate decrease since June 25, 2003. Back then, the central bank worried that deflation might descend, crippling the economy, so the Federal Open Market Committee cut the federal funds rate to a 45-year low of 1 percent to fuel economic growth. The rate remained there for a year, and then the Fed raised short-term rates 17 meetings in a row, a quarter point at a time — a gradual increase that took a little over two years. The target federal funds rate topped out at 5.25 percent in June 2006, and remained at that level until today’s decrease.

In June 2003, the Fed justified its rate cut by invoking the specter of “an unwelcome substantial fall in inflation.” The central bank succeeded in its aim of holding off catastrophic deflation. Indeed, the Fed did such a good job of suppressing deflation that it invited the opposite — inflation — but with a twist. Overall consumer prices remained under relative control, but prices of houses skyrocketed.

The fabled housing bubble occurred because the Fed made it cheap to borrow money. The federal funds rate was below 1.5 percent for 21 months. Mortgage rates were low, too. First-time and subprime homebuyers rushed in, driving up house prices. Subprime lenders, eager to make a buck, relaxed their underwriting standards. Meanwhile, from June 2004 to June 2006, the Fed was gradually raising rates.

Early this year, the double whammy of rising interest rates, plus poorly qualified borrowers, caused the subprime mortgage market to collapse. Millions of homeowners fell behind on their monthly house payments.

The Fed’s next rate policy meeting is scheduled for Oct. 30-31, with the central bank announcing its rate policy on Halloween afternoon.