Fed slashes rate to 2.25 percent

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Now that the Federal Reserve has cut rates again, this question comes up: What good will it do?

The central bank’s rate-setting Federal Open Market Committee cut the target for the federal funds rate by three-quarters of a percentage point, to 2.25 percent.

The prime rate will fall three-quarters of a percentage point, also, to 5.25 percent. Variable-rate credit cards and home equity lines of credit are pegged to the prime rate, so they will drop, too. The goal is to encourage consumers to borrow and spend more to revive the economy.

A cut of a full percentage point had been widely expected, but the Fed apparently believed that would be too inflationary: “Inflation has been elevated, and some indicators of inflation expectations have risen,” the central bank said in its policy statement. “The Committee expects inflation to moderate in coming quarters, reflecting a projected leveling-out of energy and other commodity prices and an easing of pressures on resource utilization. Still, uncertainty about the inflation outlook has increased.”

But will consumers borrow and spend more in response to lower rates on credit cards and credit lines? Maybe — but probably later rather than sooner.

“In the short term, I’m not sure it will have much of an impact at all,” says Jim Baird, chief investment strategist for Plante Moran Financial Advisors in Kalamazoo, Mich. “Clearly, when you look at consumer sentiment, there’s a lot of concern about the economy, housing and certainly the stock market. Consumers are very hesitant to stick their necks out very far.”

Fed chops rate

The Federal Reserve slashed 75 basis points off a key interest rate.

Pushing on a string
But that’s what’s happening now. There’s a lag of six to nine months before the effects of Fed rate cuts begin to be seen in the broad economy. Late this year, this hefty rate cut “is going to have an effect, but it’s got to be accompanied with some relief from anxiety, from consumers who will say, ‘I feel better buying at cheaper rates,'” Baird says.

Some commentators talk of “pushing on a string.” That’s the situation you have when the Fed keeps cutting interest rates, but lenders are afraid to lend and borrowers are reluctant to borrow. John Burford, vice president and investment portfolio manager for the International Bank of Miami, doesn’t think the Fed has arrived at that point. He feels confident that today’s rate cut will have the desired effect. Eventually. It always works, he says.

“These lower rates will get the economy going, and they will prompt consumers as long as they are employed and they are getting pay increases — not as much as they want to, but they are getting them,” Burford says. “Once this turmoil settles down, it’ll work.”

Radical steps
The key is settling down the turmoil, and the Fed has been working on that, too, by engineering the fire sale of Bear Stearns and coming up with creative ways to keep money moving through a financial system that keeps threatening to seize up with fear. Burford notes that Fed Chairman Ben Bernanke is a student of what went wrong before the Great Depression, and that the Fed has closely analyzed Japan’s mistakes in the 1990s. Those errors won’t be repeated, Burford believes, and that in itself will be a confidence-builder.

Baird notes that, until recently, people talked about whether a recession was coming. Now the questions are whether the recession has begun yet, and how long and severe it will be.

The Fed can’t do it all, though. Banks will have to loosen the purse strings, too. Lending guidelines have become especially tight with mortgages, and particularly with home equity lines of credit. Some lenders have cut their customers’ credit limits because of falling home values.

“It starts with the banks. I suspect that there are borrowers out there who would be happy to borrow if they could,” Baird says. But first, banks have to repair their balance sheets. That’s taking time.

Long-term rates, such as those for fixed-rate mortgages, don’t respond directly to the Fed’s rate decisions. Instead, long-term rates are guided by inflation expectations. They could go either way, depending on whether the bond market decides whether the Fed’s rate policy is too restrictive, too permissive, or just right.

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.