The Federal Reserve's unanimous decision to slash a key interest rate Tuesday is a dramatic statement that the central bank will do whatever it takes to prevent turmoil in the financial markets and a steep downturn in the housing sector from pulling the country into recession.
By cutting rates so sharply, the Fed indicated it hopes to put a floor under the plunging housing market, steady business hiring and investment, and keep the economy growing as it has for the last six years. A less tangible, but equally important, goal is to restore confidence in the financial markets. Investors got at least a short-term boost after the Fed's announcement, as the stock market posted its biggest one-day point rally since 2002.
Rate cuts take months to fully work their way through the economy, but consumers and businesses could quickly feel some impacts from Tuesday's cut in the federal funds rate to 4.75% from 5.25%. The fed funds rate is what banks charge each other for overnight loans.
After the Fed announced its first rate cut in more than four years, big lenders such as Wachovia, wb Wells Fargo wfc and KeyCorp. key cut the prime rate for their best customers by a half-point, to 7.75%. The prime rate also is the benchmark for the rate on many home-equity loans and credit cards. It often takes one to three monthly billing cycles for lenders to lower rates. Borrowers who take out new loans now, however, will benefit from new, lower rates.
U.S. consumers owe about $800 billion in credit card debt, and a drop of half a percentage point in interest represents about $4 billion in savings for a year's interest, says Robert McKinley, CEO of website CardTrak, which tracks credit card statistics and trends.
"That comes out to about $30 a household per month," he says.
Tuesday's action by the Fed also could lower interest rates on car loans and some mortgages, helping buyers. But savers and investors could feel a pinch as yields on bank certificates of deposit, money market accounts and money market mutual funds fall.
Yields on bank CDs and money market accounts should dip, but probably not by the full amount of the Fed's half-point cut, says Greg McBride, senior financial analyst at Bankrate.com. rate Banks still need the money from consumer deposits to fund loans, which means they will compete by offering slightly higher rates on such accounts.
Tuesday's move represents a dramatic turnaround for Fed Chairman Ben Bernanke, the Fed bank presidents and Fed board governors who voted 10-0 for the rate cut. The Fed had voted as recently as Aug. 7 to hold the federal funds rate at 5.25%.
At that time, the central bank called inflation the main threat to the economy. In later speeches, Fed officials, including Bernanke, made it clear that they were not inclined to cut interest rates to help bail out well-heeled market investors who had made bad business bets.
But Fed officials emphasized that they would act if problems in the financial market were infecting the broader economy. As it became clear in recent days that tightening credit had the potential to exacerbate the housing slump and affect consumer and business spending, the Fed responded.
"Today's action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise," the Fed said in its statement announcing the rate cut.
Another rate cut coming?
The central bank said it would closely monitor financial conditions and "act as needed" to promote steady economic growth and stable inflation. It did not give a clear indication whether another rate cut is in the offing, but many economists expect it.
"Bold action was needed … and bold action is what the Fed delivered," says Brian Bethune of economic consulting firm Global Insight, who predicts the Fed will cut rates again when it next meets Oct. 30-31.
The central bank also cut its discount rate, which is what it charges banks for direct loans, by a half-percentage point to 5.25%. The Fed has now cut the discount rate twice since Aug. 17 in an effort to get credit flowing in financial markets.
Aside from the two discount rate cuts, the Fed in recent weeks has taken several other actions to try to stabilize financial markets, including injecting larger-than-usual amounts of money into the financial system to help banks.
Not everyone approves
The Fed's move provides evidence that Bernanke — in office since February 2006 when he replaced legendary chairman Alan Greenspan — is not afraid to take strong action and is able to forge consensus on the board at a time when the outlook is unclear.
The decision was not without controversy. Some economists called it too sweeping, saying conditions in the financial markets are not as dire as the Fed indicates. Exports have been steady, and the unemployment rate is a low 4.6%, despite the unexpected loss of 4,000 jobs in August.
The critics say that although the inflation rate has fallen in recent months, cutting interest rates too much now could overstimulate economic activity over the long run, raising the threat of higher prices — and higher interest rates.
First Trust Advisors chief economist Brian Wesbury says the Fed used a "very broad tool to try to fix a specific problem," namely issues with higher-cost subprime mortgages to those with poor credit. Homeowners' inability to repay such loans has led to record levels of foreclosure and helped to drive down home prices.
"This is a move to try and calm market fears, but it is a move that will have little effect on the economy and, in fact, will lead to further rate hikes and potential problems with inflation down the road," Wesbury says.
The inflation rate has come down as growth has slowed, including a dip in wholesale prices in August. Still, the Fed can't relax completely. Oil prices closed at a record $81.51 a barrel on Tuesday, though they have been higher on an inflation-adjusted basis. Retail food inflation is up more than 4% in the past year.
A big worry in the bond market is that the Fed's rate cut will fuel inflation, which erodes the value of a bond's interest payments. After the Fed's announcement Tuesday, the yield on the benchmark 30-year Treasury bond rose to 4.75% from 4.71%.
The financial markets also displayed inflation worries by driving up the price of gold, a traditional hedge against inflation, to a 27-year high of $732.70 an ounce in the futures market.
The dollar fell against the euro — to $1.397, a new low — as investors shifted their money to Europe, where interest rates are higher.
Two big problems
In addressing problems in the financial markets, the Fed faces two related issues.
One is turmoil in credit markets, which began with the rising foreclosures among homeowners with subprime mortgages. The Fed also is mindful that 2 million adjustable-rate subprime loans will reset to higher interest rates by the end of next year, potentially pushing foreclosures far higher.
Many subprime loans were repackaged into bonds that were sold to investors worldwide. Some major banks and hedge funds that bought the bonds have taken major financial hits. That has mushroomed into a broader lack of confidence about many financial products.
The upshot is tighter credit, with some banks now forced to hold more loans, making them less willing and able to lend. That has driven up borrowing costs for consumers.
Those with good credit are finding it harder to get financing, and those with shaky credit have dwindling options.
Tighter credit reinforces problems in the housing market, where new home construction is down more than 20% from last year, and builders are holding huge inventories.
Credit problems also make it more difficult for consumers to refinance their mortgages or take out home-equity loans, harder for builders to sell homes and easier for home prices to keep falling.
The Fed's move could affect housing markets in several ways. First, it should help strapped builders, many of whom have construction and development loans tied to prime rates.
As they have been forced to hang on to houses longer, their costs have risen, says Dave Seiders, chief economist for the National Association of Home Builders.
Jumbo-loan market tightens
Some borrowers with good credit had seen a slight reduction in mortgage rates in recent weeks as investors fled to safer Treasury bills, a move that pushed down long-term rates. Rates for conventional 30-year, fixed-rate mortgages were about 6.31% last week, according to mortgage giant Freddie Mac, fre down from 6.43% a year ago.
But the benefits aren't being felt in the market for "jumbo" loans — those for more than the $417,000 limit that Fannie Mae fnm and Freddie Mac can buy and repackage into mortgage-backed bonds.
The secondary market for jumbo mortgages has tightened, so interest rates on such loans are significantly higher.
Tuesday's rate cut "will start the process of the liquidity problems coming to an end," says David Berson, Fannie Mae's chief economist. "In a small way, some (lenders) will be more willing to hold jumbo mortgages, for example."
But mortgage rates typically follow the 10-year Treasury note yield, which rose slightly after the Fed's rate cut but closed unchanged.
Borrowers with adjustable-rate loans could be getting some relief, McBride says. "Their rates will adjust higher but not as high as they would have, and that's significant for some. It could be the difference between keeping their home and losing it."
About half of all adjustable-rate mortgages use short-term Treasury securities as the benchmark for resetting rates, says Keith Gumbinger, vice president of HSH Associates, which tracks mortgage rates. Those rates have fallen sharply in the past few weeks as investors have snapped them up in search of a haven. But roughly half of adjustable-rate mortgages — and most subprime mortgages — are pegged to the London Interbank Offered Rate, or LIBOR, which has remained stubbornly high because banks have become more reluctant to lend.
Even a deeper rate cut by the Fed might not solve the problems of many homeowners with adjustable-rate subprime mortgages.
The problems in the subprime market are not just the cost of the credit, but the fact that many lenders approved loans that borrowers could not repay — with provisions such as escalating interest rates and penalties for early repayment.
Thursday, Bernanke will appear at a hearing on Capitol Hill concerning White House plans to help stressed subprime borrowers.
Some of those most likely to be helped by the Fed move thought the central bank went too far.
"I would have done a quarter (of a percentage point) instead of a half because this sends a message we're in deep doo-doo," says Robert Toll, CEO of luxury-home builder Toll Bros., tol who adds that the cut won't do much to help the subprime market.
Will consumers curb spending?
A related issue is whether falling home prices will limit consumer spending, as homeowners are less able to borrow against the equity in their homes. Economists are split on the issue.
A rate cut has other effects. It can make the USA a less attractive place for foreign investment and push down the value of the dollar against other currencies. A falling dollar helps exports, which have been a bright spot for the economy, but makes imports more costly.
Dan Meckstroth, chief economist at Manufacturers Alliance/MAPI, says the full effect of the rate move will be gradual.
"Interest rates … take a long time to filter in. It's not an overnight turnaround," he says.
Contributing: Noelle Knox