Tuesday’s rate cut: Part medicine, part sugar pill

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Fed watchers expect the Open Market Committee will cut the key overnight lending rate on Tuesday to put a little bit of money in your pocket and a spring in your step.

Many economists expect the Federal Reserve committee will reduce the target federal funds rate from 2.5 percent to 2.25 percent. A few observers believe the Fed will cut the rate all the way to 2 percent on Tuesday.

A rate cut would be aimed at increasing spending by businesses and consumers, and giving people a psychological lift.

What’s in a rate cut?
When the Fed changes the federal funds rate, the prime lending rate adjusts immediately by the same amount. Other short-term interest rates — for credit cards, auto loans, certificates of deposit and home equity lines of credit — follow the prime rate’s trend, but not always in lock step. Long-term mortgage rates tend to move in advance of Fed rate cuts.

At first glance, it appears that a Fed rate cut wouldn’t affect consumers much. Many credit cards have reached their minimum interest rates and won’t go lower. Thousands of people are taking advantage of zero-percent auto loans. Home equity lines of credit have minimum monthly payments, so a lower interest rate won’t necessarily mean a lower payment.

All true, acknowledges Greg Mount, senior economist for Bank One. Still, he thinks that a small reduction in the federal funds rate would benefit consumers.

Take credit cards. Mount points out that lots of people get credit card offers in the mail every week. If you are at your card’s minimum interest rate, you might get an offer for a card with a lower minimum interest rate, or no minimum rate at all. If the Fed lowers the federal funds rate, some of the credit card offers you get could be even more appealing.

Mount says a lower prime rate would decrease businesses’ borrowing costs, allowing them to pass along savings to consumers if they want to. In the case of automakers that offer zero-percent loans, the lenders might lose less money on each loan if the Fed lowers interest rates. In response, automakers could continue offering interest-free loans past the current expiration dates of those offers.

The Fed as shrink
Although an interest rate cut might give consumers more money to spend, its effect could be more psychological than financial. Lots of economists see a Fed rate cut as a way to jolt people out of their economic languor.

“What is at issue isn’t that people can’t afford to buy, but the unwillingness because of uncertainty and fear,” says Joel Naroff, president of Naroff Economic Advisors. “They’re not going to take trips over Christmas; they’re going to stay home. They might have a good Christmas for the kids, but that may be it.”

People are right to feel uncertain and fearful. A drive to the airport might entail a vehicle search at the entrance of the parking lot, and National Guard troops with rifles monitor terminals. Anthrax is in the mail. Almost 3.7 million people are collecting unemployment benefits. Nearly 499,000 people filed jobless claims just last week. To put that in perspective, that’s about the population of Tucson, Ariz.

A few anthrax deaths somewhere on the East Coast might be scary, but when half a million people lose their jobs in one week, that hits home. It might affect you. Or it might affect someone in your neighborhood or your family. Either way, it makes you think twice about making a trip to the mall. Maybe your shoes could last one more season, and maybe you can wait until those post-Christmas sales to buy that DVD player you’ve had your eye on.

An interest rate cut would be the Fed’s way of saying that it’s paying attention to the misery and fears out there, and it’s doing what it can to help.

How much is enough?
The Fed’s Open Market Committee already has cut the federal funds rate nine times this year, dropping the rate from 6.5 percent to 2.5 percent. Right now, the rate is at its lowest level since the Kennedy administration.

Most economists think the Fed gives itself more maneuvering room if it lowers the funds rate by a quarter of a percentage point Tuesday rather than a half point. The committee always can cut the rate between its regularly scheduled meetings — it did that three times in 2001 — and it meets again on Dec. 11.

The first meeting of 2002 is Jan. 29 and 30.

Investors at the Chicago Board of Trade have arrived at a consensus that says the Fed will cut the rate by a quarter of a percentage point on Tuesday and another quarter-point by the end of the year, taking the rate down to 2 percent.