Why the Fed will cut rates again

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The Federal Open Market Committee met yesterday and is meeting today, and the tenuous nature of the credit market assures another rate cut is coming our way. Because Fed interest rate cuts typically take six to nine months to completely filter through the economy, how will the move help in the short-term?

The primary, and most immediate, impact of Fed action will be in the corporate, rather than the consumer, sector. Witness the stock market’s euphoric 335-point rise in less than two hours of trading following the Fed’s Sept. 18 announcement.

Another Fed rate cut serves to grease the skids in the all-important commercial paper market where large corporations turn for short-term funding needs. Companies’ hoarding of cash deprives the commercial paper market of the breathing room needed to function, which can drive interest rates drastically higher.

On the other side of the ledger, sharply higher borrowing costs can impair the ability of companies needing cash to meet obligations or make needed investments. By taking the two steps of pumping liquidity into financial markets and reducing short-term borrowing costs — as the Fed has been doing — markets can return to normal operations. What exactly are normal operations? Normal operations would be regular breathing, as compared to the shortness of breath that has been lingering since August. The regular breathing of normal market operations is a basic component of economic growth.

After all, if everyone everywhere sits on piles of cash, not lending or borrowing, how does an economy grow?

Effect on consumers
This is not to say that the consumer is left out. Consumers have been and will be beneficiaries of the Fed lowering rates. Rates on
home equity lines of credit have dropped 50 basis points since the September Fed cut, and
credit card rates have declined in four of the five weeks since that move.
Mortgage rates have revisited the levels seen just prior to September’s Fed gathering, erasing the spike seen in the aftermath of the Fed cut.

And savers can thus far breathe a sigh of relief as deposit yields have hung tough despite the Fed’s larger-than-expected half-point move in September and even more pronounced declines in Treasury yields since August. The top-yielding
savings accounts,
money market deposit accounts and
certificates of deposit — regardless of maturity — remain well clear of the 5 percent mark, and another cut by the Fed doesn’t necessarily threaten to violate that threshold.

Credit market risk still exists
But the Fed’s action is warranted by the dark cloud hanging over the economy — the conditions in credit markets. Yes, the housing market is a consideration, but cutting interest rates isn’t going to make housing all sunshine and daffodils overnight, and the Fed is keenly aware of that fact. It will take time to weather the storm of the housing market, but that won’t happen without the normal functioning of credit markets to support business and consumer spending. And the economy won’t continue to expand if businesses and consumers stop spending.

Which brings us back to the most immediate impact of a Fed rate cut being in the corporate rather than consumer sector. Perhaps consumer spending isn’t likely to stop in its tracks. After all, incomes continue to grow, the labor market is tight, and as long as I continue to see a line of people willing to pay $4 for a cup of coffee, consumer spending is unlikely to roll over. But business investment is much more susceptible to a cold-turkey turnaround, and another Fed rate cut should keep that scenario at bay.