The Federal Reserve has cut a key short-term interest rate for the second time in a row.

The central bank’s rate-setting committee lowered the target for the federal funds rate by one-quarter of a percentage point, to 4.5 percent. The prime rate will fall to 7.5 percent. Consumer interest rates based on the prime rate — mainly home equity lines of credit and most variable-rate credit cards — will fall a quarter-point in coming weeks.

Fed chops rates
4.5%

The Federal Reserve shaved a quarter point off a key short-term rate.

Normally, you would expect yields on certificates of deposit to fall, too — especially shorter-term CDs. But that’s not necessarily the case this time. It’s not a sure thing that mortgage rates will fall, either.

Most economists and investors had expected this rate cut because they believed the Fed would want to address the bursting of the real-estate bubble in many of the country’s biggest metro areas.

The Fed explained its action by saying that economic growth was solid from July through September, but “the pace of economic expansion will likely slow in the near term, partly reflecting the intensification of the housing correction.”

The rate-setting committee cautioned that “some inflation risks remain” because of rising energy and commodity prices, and that the risks of inflation and an economic slowdown are roughly in balance.

In September, the last time the rate-setting Federal Open Market Committee, or FOMC, met, the panel cut the federal funds rate by half a percentage point. That was the first time in more than four years that the Fed had made a rate move, in either direction, of more than a quarter of a percentage point.

“A quarter-point cut would be done in the spirit of insurance, rather than a firm belief that it’s necessary,” said Richard DeKaser, chief economist for National City Corp., before the Fed’s announcement. DeKaser had put himself in what he called “the ultraminority camp” of economists who expected the central bank to keep rates unchanged.

DeKaser said he believes that problems in housing markets are transitory, and that he isn’t convinced that the Fed should try to solve them, because it then might create other troubles. The central bank, he said, “also has to worry about inflation, and it’s not out of the woods on that front.”

Fed cred
For other observers, the issue was the Fed’s credibility. The markets had priced in a near-certainty that the central bank would reduce the federal funds rate by a quarter of a percentage point. Any other move would have scared investors.

“I think that a quarter percent (cut) is baked in the cake, pretty much, and I think they’re doing the right thing,” Bill Hummer, chief economist for Chicago-based Wayne Hummer Investments, said before the Fed announcement. “They have to reinforce confidence, which is still fragile in some sectors of the economy.”

The quarter-point cut reinforces confidence in a number of ways, Hummer says: It meets investors’ expectations, sets aside the notion that the Fed is still preoccupied with the threat of inflation, and tells big financial institutions that the central bank recognizes the problems they’re having with the fallout from the subprime mortgage debacle.

In Hummer’s estimation, a quarter-point cut gives the Fed more options. When the rate-setting panel meets next month, it’s free to do nothing, cut a quarter-point or cut a half-point, without lending the impression that it’s veering off course.

Rate-cut effects
Fed rate cuts don’t always have the expected effects. Yields on certificates of deposit usually follow the Fed. But when the Fed cut half a percentage point on Sept. 18,
high-yield CDs didn’t fall nearly as much. On Sept. 18, the average yield on a one-year, high-yield CD was 5.2 percent, according to Bankrate’s weekly survey; the average yield had fallen 12 basis points, to 5.08 percent, five weeks later. Over the same time, three-month high-yield CDs dropped 20 basis points, from 4.93 percent to 4.73 percent.

Mortgages don’t always react as expected, either. The 30-year fixed averaged 6.32 percent nationally the day after the Sept. 18 Fed rate cut. It rose and then fell — ending up at 6.31 percent last week.

Banks charge the federal funds rate to one another for overnight loans. The Fed controls the federal funds rate indirectly, by selling and buying securities to add and subtract cash from the banking system. Eight times a year — roughly every six weeks — the FOMC meets. The prime rate is 3 percentage points higher than the federal funds rate.

Historical perspective
At the beginning of 2001, the Federal Reserve cut short-term interest rates swiftly — 3 percentage points in four months — to cushion a recession. More gradual rate-cutting followed. Starting in June 2004, the Fed raised rates, a quarter-point at a time, for two years. Now the Fed has cut the federal funds rate twice in a row, and there’s no telling how many are to come.

Federal funds rate 2001-2007