What Fed cut means to economy

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The Federal Reserve has cut short-term interest rates again. The goals of this action are to encourage consumers to borrow, but even more important, to induce banks to lend.

For consumers, borrowing comes as naturally as overeating during the holidays, and there’s little need for the Fed to provide an incentive to borrow. But lenders have been reluctant to part with cash since summer. Their tight-fistedness has worsened the housing downturn, which has caused lenders to be even more cautious about lending.

Fed chops rate

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

That’s where the central bank steps in. In an effort to get more money circulating, the Federal Reserve’s Open Market Committee reduced two short-term interest rates today. It cut the target for the federal funds rate by a quarter of a percentage point, to 4.25 percent, and slashed the little-used discount rate a quarter of a percentage point, to 4.75 percent.

The cut in the federal funds rate is aimed at stimulating demand among consumers and businesses. The lower federal funds rate means that the prime rate will fall a quarter point, to 7.25 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.

Stimulate the banking system
Consumers are not the audience for the other rate that the Fed cut: the discount rate. The reduction in the discount rate is intended to add money to the international banking system. Think of that money as oil that keeps the system running smoothly.

“Incoming information suggests that economic growth is slowing, reflecting the intensification of the housing correction and some softening in business and consumer spending,” the rate-setting Open Market Committee wrote. “Moreover, strains in financial markets have increased in recent weeks. Today’s action, combined with the policy actions taken earlier, should help promote moderate growth over time.”

The committee said it still sees a risk of rising prices and “will continue to monitor inflation developments carefully.” A reduction in interest rates always carries the possibility of higher inflation.

The vote to raise the federal funds rate by a quarter point was not unanimous. Eric S. Rosengren, president of the Federal Reserve Bank of Boston, wanted to lower the federal funds rate by half a percentage point instead of a quarter point.

In cutting the discount rate, the Fed’s goal is “to get banks in the mode of wanting to lend,” says Ronald Kiddoo, chief investment officer for Cozad Asset Management in Champaign, Ill. Problems with subprime mortgages have spread to other types of home loans, causing a rise in foreclosures and making banks afraid to lend to consumers and to other banks, too.

As a result, Kiddoo says, bankers “are concentrating on preserving the current loans instead of making other ones. They’re not devoting time to getting new business but to reducing loan losses.” It’s not only a financial problem, but a psychological issue, too.

How does the Fed fix that defensiveness? By cutting short-term rates enough to allow banks to reduce the rates they pay to depositors, says John Burford, vice president and investment portfolio manager for The International Bank of Miami. Banks will become more profitable, and more willing to lend, if the rates they pay to depositors fall more than the rates banks charge to borrowers.

Reflate the housing market
Burford believes that the Fed wants to heal the housing market. The home building and mortgage lending industries are in recession, and many observers worry that they’ll drag down the entire economy with them.

“That’s where this mortgage situation comes in,” Burford says. “To maintain that, they (the Fed) are in the process of reflating housing. They’ve got to get inflation back in the housing business. They can’t come out and say that, but that’s what they want. The way to do that is, essentially, to put a lot of money in the system.”

Marc Schwaber, president of Preferred Empire Mortgage in Melville, N.Y., agrees that housing threatens to weaken the economy. Lowering the federal funds rate, and therefore the prime rate, will help, Schwaber says. But lower rates are insufficient.

What’s needed is a higher limit for conforming mortgages and Federal Housing Administration-insured home loans, Schwaber says. Those actions would stimulate homebuying and boost the overall economy, he says.

How the Fed controls the system
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. The prime rate is 3 percentage points higher than the federal funds rate.

Sometimes banks borrow directly from the Federal Reserve. They pay the discount rate on those loans. For years, there has been a stigma attached to borrowing via the discount window. The Fed has been trying to eliminate the disgrace, but it hasn’t been erased yet. That limits the effectiveness of cutting the discount rate.

The Open Market Committee meets eight times a year, roughly every six weeks. The next meeting is scheduled for Jan. 29 and 30, with the rate policy announcement coming on the latter day.