The target for the federal funds rate, which is what member banks charge one another for overnight loans, drops half a percentage point, to 1.5 percent. The reduction means that the prime rate will fall to 4.5 percent from 5 percent. Variable-rate credit cards and home equity lines of credit are linked to the prime rate, so consumers will see a drop in the rates on those kinds of debt in the coming weeks.
Economic activity has “slowed markedly in recent months,” the Fed’s rate-setting committee said in a statement, adding: “Moreover, the intensification of financial market turmoil is likely to exert additional restraint on spending, partly by further reducing the ability of households and businesses to obtain credit.”
Credit has been drying up, especially to businesses. Credit crunches have a way of squeezing the vitality of the economy because businesses have trouble borrowing money with which to buy supplies and pay employees. As workers’ paychecks shrink because of layoffs and reductions in hours, consumers buy less — and thus begins a cycle of reduced economic activity. The Fed’s rate cut is designed to interrupt that cycle.
In good economic times, low interest rates invite inflation. These haven’t been good economic times, but inflation has been high anyway, mostly because of high oil prices. Those prices have been falling in the last couple of months. The Fed said it believes that “the decline in energy and other commodity prices and the weaker prospects for economic activity have reduced the upside risks to inflation.”
The rate cut decision was unanimous. The Fed cut another rate, too: the discount rate, which is what financial institutions pay when they borrow directly from the Fed. The discount rate was reduced half a percentage point, to 1.75 percent.
The Fed’s announcement came in two parts: a joint statement by seven central banks, followed by the Fed’s own statement.
The joint statement announced that the Fed, the Bank of Canada, the Bank of England, the European Central Bank, the Bank of Sweden and the Swiss National Bank were all cutting rates by half a percentage point. The Bank of Japan expressed “its strong support.”
The joint statement explained: “Inflationary pressures have started to moderate in a number of countries, partly reflecting a marked decline in energy and other commodity prices. Inflation expectations are diminishing and remain anchored to price stability. The recent intensification of the financial crisis has augmented the downside risks to growth and thus has diminished further the upside risks to price stability.”
The Bank of Japan’s overnight rate is 0.5 percent, so it didn’t have room to cut by half a percentage point. It said its financial market “has been stable in comparison with those in other industrialized countries.”
Along with Wall Street, the world’s other financial megacenter is the City of London, where the Bank of England issued a lengthy explanation of its half-point rate cut to 4.5 percent. “Conditions in international credit and money markets have deteriorated very markedly,” the Bank of England said. “Many markets are closed. In the United Kingdom, the supply of credit to households and businesses is clearly tightening further as banks seek to adjust their balance sheets.”
The Bank of England acted around the same time that the United Kingdom’s treasury announced a partial nationalization of banks, in which the U.K. will pour up to $87 billion into the banks in exchange for an ownership stake. Referring to this dramatic plan, the Bank of England said in its announcement: “The Committee noted that cuts in official interest rates could not be expected to resolve the current problems in financial markets and that a significant increase in the capital of the banking sector would be required.”
Back in the United States, some experts have been saying that the government eventually will need to invest in banks, too — that the $700 billion bailout will address problems with short-term availability of money within the banking system, but won’t be sufficient to keep the banks healthy enough to keep lending to consumers and businesses.
The Federal Reserve, concerned about an economic slowdown, began cutting the federal funds rate 13 months ago. It rapidly slashed the rate from 5.25 percent to 2 percent between September 2007 to April of this year. Over the summer, economists and investors began to speculate that at least one more rate cut would be forthcoming, and they were right.
Long-term rates, such as those for mortgages, don’t respond directly to the Fed’s short-term rate moves. Sometimes mortgage rates move in the opposite direction when the Fed reduces the federal funds rate. But more often than not, mortgage rates eventually follow the Fed’s lead. That might be one of the motivations of the central bank, DeKaser says — “to help the housing market by lowering the refinance rate on many resetting mortgages. That makes it easier for people confronting resets, which we know are rampant right now, to achieve more affordable rates.”
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.