Interest rates are getting lower. Again.
A Federal Reserve committee cut the federal funds rate by one-quarter of a percentage point Wednesday, to 1 percent. The prime rate will fall to 4 percent.
Consumer interest rates based on the prime rate — those for some (but not all) home equity loans, home equity lines of credit, and auto loans — will fall by a quarter of a point, too. Rates on some variable-rate credit cards will fall if they haven’t already reached a floor below which they cannot drop.
When the Fed’s Open Market Committee cuts short-term rates, it’s usually to stimulate the economy. Lower interest rates encourage consumers and businesses to borrow money and spend it on goods and services. That, in theory, keeps the economy humming along.
The Fed indicated that the economy, though frail, just needs another gentle push to achieve full recovery. The economy “has yet to exhibit sustainable growth,” the Fed said in its announcement. “With inflationary expectations subdued, the Committee judged that a slightly more expansive monetary policy would add further support for an economy which it expects to improve over time.”
The federal funds rate is also called the overnight rate because it is what banks charge one another for overnight loans. The last time it was lower was in July 1958, when the overnight rate averaged 0.68 percent. The Fed has cut the overnight rate 13 times since the beginning of 2001, when the rate was 6.5 percent.
Mortgage rates, which are near 45-year lows, aren’t influenced directly by the Fed’s short-term rate moves. Many observers expect long-term mortgage rates to rise gradually, despite the Fed rate cut. Rates on certificates of deposit will dwindle further, applying more pressure to retirees.
“People who are appropriately invested 100 percent in fixed income, their income is measly right now,” says Patricia Advaney, vice president for Diversified Investment Advisors in Purchase, N.Y. “They’re in more of a dilemma.”
Most observers expected the cut by the Fed’s rate setting Open Market Committee, although they disagreed whether it would be by one-quarter or one-half a point. Some economists argued that a cut was unnecessary because the economy already shows signs of reviving. Those signs show up in the rallying stock market, though, not in the dismal job market. Every week, more than 400,000 people apply for unemployment benefits.
In the last week, the conventional wisdom evolved. The new mantra went like this: It’s not the Fed’s rate action that matters — it’s the Fed’s explanation that matters.
That became the conventional wisdom because of what happened after the Fed’s last meeting, in May. Seven weeks ago, the Fed didn’t touch interest rates, but issued an explanation that stoked the stock and bond markets at the same time — quite a feat.
After the meeting on May 6, the Fed said that it would use interest rate policy not only to encourage the economy to grow at a sustainable rate, but also to ward off deflation. In a deflationary economy, overall prices keep dropping, so people stop buying things because prices will be lower in a month or two. As consumers snap shut their pocketbooks, more people lose their jobs, and those people snap shut their pocketbooks, causing more people to lose their jobs.
The Fed’s statement was taken as a signal that the rate-setting body would keep short-term rates low for a long time. Long-term mortgage rates reacted by falling, and that spurred a refinancing boomlet in the last month.
This cut “will continue to boost the mortgage refinancing and all that, which is a good thing,” Advaney says. She doesn’t think the rate cut really is necessary, though, and that an overnight rate of 1.25 percent was enough. “There is a tendency to overreact and overengineer,” she says. “I think if we let things play out, things should turn around.”
The recession that began in early 2001 and probably ended late that year was shallow. It would have been deeper had it not been for low mortgage rates and the resulting refinancing boom, which put cash into consumers’ pockets. Consumers have been keeping the economy afloat, and the Fed is trying once more to invite businesses to the party, says Ellen Bitton, president of Park Avenue Mortgage in New York.
“I think their focus is to reduce rates and continuously stimulate the economy and to make it easier for businesses to start purchasing, which is what needs to happen,” she says. “In order for these companies to grow, they have to start investing in machinery and people and all kinds of things. I think that’s the focus of the Fed cut. The refinancing boom is a byproduct.”
Will the rate cut have the intended effect of encouraging businesses to spend? “Evidently the markets think so,” Bitton says.
The markets think another thing, she adds: That this is it for interest rate cuts, that “this will be as good as it gets as far as the bond market and interest rates go. This is our summer to retrench — not just to refinance mortgages, but to finance machinery and computers and growth for businesses that will bring us at least through the next couple of years.”