The Federal Reserve cut key a short-term interest rate by a one-quarter percentage point as "insurance" against deflation, a prolonged and rapid decline in prices. But how does the rate cut affect consumers and businesses?
First off, the cut is in the federal funds rate, which is what banks charge each other for overnight loans.
When the Fed cuts its target for the Fed funds rate it is signaling that it is making more cash reserves available to the banks. More money in the system lowers the cost of borrowing.
So what's the impact on consumers?
When the Fed lowers the Fed funds rate, banks generally lower their prime rates, often immediately. That's good for consumers shopping around for auto loans, personal loans and home-equity lines of credit or who have variable-rate credit cards, all of which are tied to the prime. Those rates should drop.
Auto loans are averaging 7.31 percent for a 48-month loan, according to Bankrate.com — remember most customers do not get the much-advertised zero-percent financing. Cheaper borrowing costs might prompt more consumer spending, which could stimulate the economy.
The bad news for consumers?
The prime is also used to set rates on CDs, money market accounts and checking accounts that pay interest, so the return on those will be less. The return on a CD is already very low, averaging about 1.1 percent for a 1-year, according to Bankrate.com.
But remember, there's no impact of these rate cuts on home mortgage rate, which are not tied to the Fed funds or prime rates. Instead, home mortgage rates are tied to the yield on the 10-year Treasury note.
Right now, partly because the economy is weak, investors have been putting more money into bonds and Treasury notes, which has brought yields to 40-plus year lows.
That has pushed mortgage rates to record lows. As of this morning, the 30-year fixed rate was averaging 5.10 percent, up from the recent record low of 4.99 percent, according to the Mortgage Bankers Association of America.
To illustrate that the Fed's actions and mortgage rates do not work in tandem, here are dramatic examples:
The Fed cut rates 5 times from January 2001 to June 2001, from 6.50 percent to 4.00 percent. During that same period of time, mortgage rates went up from an average of 6.98 percent to 7.17 percent.
And from December 2001 until November 2002, the Fed took no action. During that period, mortgage rates went down from an average of 7.15 percent to 5.96 percent.
So, what's the impact of a rate cut on businesses?
Businesses needing to borrow money could do so cheaper because of a rate cut. They'd pay lower interest rates, which could increase profits.
Lower borrowing costs also could mean more cash for businesses to spend, which would stimulate the economy.