Fed Cuts Key Rate

Here is a series of Q's and A's on the Fed's cut today. My take on it is that we have some real problems here with the banking system in this country and nobody wants to fess up on what's really happening - Tom


WASHINGTON — The Federal Reserve reduced its benchmark interest rate by three-quarters of a percentage point on Tuesday, to 2.25 percent, a cut that was less than investors had been hoping for even though it was one of the deepest in Fed history.


Falling interest rates may be a boon to borrowers, but they can be hard on savers and retirees on fixed incomes.
On Tuesday, the Federal Reserve cut its key short-term interest rate three-quarters of a percentage point to 2.25 percent -- a move designed to spur banks, credit card issuers and other financial institutions to lower their rates as well.
It was the sixth cut since September, and it pushed the rate a full three percentage points below the 5.25 percent that prevailed last summer.
Here is how borrowers and savers are faring in the lower-rate environment.
Q:How does the Federal Reserve action affect the interest rates on consumer products?
A:When the Fed lowers its federal funds rate, which is the interest banks charge each other on overnight loans, the financial institutions typically pass on the lower rates to borrowers and savers. Shortly after the Fed acted, many of the nation's big banks lowered their prime lending rate to 5.25 percent from 6 percent.
Q:Will consumers see lower rates on their credit cards?
A:Probably, but not right away, said Greg McBride, senior financial analyst with Bankrate.com.
"Card issuers tend to pass along rate increases more quickly than rate decreases," he said. The lag is typically up to three months, and the reduction may not match the Fed's cut, he added.
The average rate on a variable-rate credit card six months ago was 14 percent; now it is about 12.35 percent.
Another maneuver that can reduce the benefit for consumers is that some card issuers switch to fixed rates from variable rates to keep their profits from dropping.
Q:What about home mortgage loans?
A:"The biggest beneficiaries of the repeated rate cuts are homeowners facing resets with adjustable-rate mortgages," McBride said.
That is because the rate on many of these home loans is pegged to the rate on the one-year Treasury bill, which tends to move down after Fed rate cuts.
"Last summer, borrowers with an adjustable-rate mortgage pegged to one-year Treasuries could have seen their rate jump by 3 percentage points," McBride said. "Now, borrowers could see their rate decline."
So a family with a $200,000 home loan would have seen a $370 increase in monthly payments if the rate adjusted last summer, but a loan that reset this spring would have a $50 per month decline, he said.
Q:Will fixed-rate mortgages be affected?
A:These loans typically reflect the rate on 10-year Treasury notes, and this is affected more by conditions in credit markets and inflationary expectations than by Fed action on short-term rates. Fixed-rate mortgages currently are being offered a bit below 6 percent now, not much of a drop from the high around 6.8 percent last July, Bankrate.com estimates.
Q:What about homeowners with lines of credit?
A:Borrowers with outstanding lines of credit should see their monthly payments drop as the rate on these loans falls in line with the prime rate, said David Tysk, a senior financial adviser with Ameriprise Financial in Minneapolis.
He said that a client with a $100,000 outstanding line of credit already has seen a $180 drop in his monthly payment and could see that rise to more than $200 after the latest Fed action.
Q:What about savers?
A:As the Fed has lowered rates, the return on savings accounts and many short-term investments has fallen, too.
Tysk noted that the yields on certificates of deposit are down and that investment alternatives such a municipal bonds and money market funds "are not doing well in the current climate."
He said that what a consumer should do depends on his or her short-term needs -- and comfort level.
Tysk said one concerned client recently moved a big chunk of his savings to federally insured bank accounts and government securities. "Consumer sentiment is very real," he said.
Q:How are retirees and others living on fixed income feeling the pinch of lower rates?
A:"If you are a retiree, these are tough times," Tysk said. That is because returns on savings are down while costs -- from gasoline to heating oil, health care and food -- are rising.
The retirees, he added, are finding a variety of ways to cope.
Some have been borrowing, perhaps to pay for a new furnace or car, because paying a low rate on a loan beats paying tax of 25 percent or more on a withdrawal from an Individual Retirement Accounts or a company-sponsored retirement savings plan, he said.
"They also have an incredible ability to adapt ... delaying purchases, home projects, things like that," Tysk said.
Q:Is the Fed finished?
A:Mark Vitner, senior economist with Wachovia Corp. in Charlotte, N.C., thinks there is room for more rate cuts.
"They probably have to overdo it, and then take some back later in the year or next year," he said. He described the Fed action to date as "a full frontal assault on the credit crunch. They're hitting with everything they've got. It's pretty remarkable. I think six months from now we'll look back and marvel at how creative the Fed was and how successful they were."
While leaving the door open for additional rate cuts, policy makers also expressed growing concern about inflation. "Uncertainty about the inflation outlook has increased," the central bank said. "It will be necessary to continue to monitor inflation developments carefully."
The statement highlighted the growing problem that the Fed faces, between fighting an economic downturn and heading off new inflationary pressures that have become apparent in everything from energy and food prices to the falling value of the dollar.
In a sign of the difficult choices the Fed faces, two of the 10 members of the policy-making Federal Open Market Committee dissented from the decision, favoring a smaller rate cut.
The two dissenters in Tuesday's decision were Richard W. Fisher, president of the Dallas Fed, and Charles I. Plosser, president of the Philadelphia Fed, both of whom have been outspokenly hawkish about inflation issues in recent months.
The Fed's announcement was the culmination of an extraordinary series of actions over the past two weeks to prop up financial markets and the economy with a flood of cheaper money.
The Federal Reserve has reduced its overnight lending rate, the federal funds rate, six times since September, and did so twice in January alone.
With the latest reduction, the federal funds rate is far below the rate of inflation, meaning that the "real," or inflation-adjusted, rate is below zero. It is also well below the European Central Bank's benchmark interest rate of 4 percent or the Bank of England's rate of 5.25 percent.
On the edge of panic
Investors had already assumed that the central bank would reduce the cost of borrowing by at least another three-quarters of a percent on Tuesday, but mounting worries about a meltdown in financial markets and the Fed's emergence as lender of last resort had elevated expectations even higher.
Indeed, expectations about another deep cut in interest rates were so high that the central bank was at risk of setting off a new wave of panicky selling if it had announced a reduction of less than three-quarters of a percentage point. In fact, the Dow Jones Industrial Average began falling after the announcement of the Fed action before reversing course and finishing the day up 420.41 points at 12,392.66, its highest one-day gain in five years.
A lower federal funds usually leads to lower interest rates for mortgages, consumer loans and commercial borrowing.
But Fed officials had been startled and frustrated that their previous rate reductions were doing nothing to lower the long-term interest rates that are most relevant for expanding a business or buying homes or cars.
Part of the reason, analysts said, is that lower overnight interest rates have only limited relevance to the fundamental problem that is roiling the credit markets and the economy: the huge losses caused by the collapse of the housing bubble and the home loan environment that fed it.
Most analysts predict that housing prices, which have already fallen in most parts of the country, will drop much further before they hit bottom.
About 8 million homeowners already owe more on their mortgage than their houses are currently worth, and foreclosure rates have soared over the past year.
The Fed's problem is that its primary tools for stimulating growth -- reductions in the cost of borrowing -- do little to address the fears about bad loans. Many if not most private forecasters have concluded that the United States has probably entered a recession. The Labor Department has reported back-to-back declines in payroll employment in January and February.
And while the unemployment rate is still low at 4.8 percent, the number of private-sector jobs has declined for three months in a row -- a pattern that has almost always been accompanied by a recession in recent decades.
Bailing out banks
With financial markets becoming dysfunctional, Fed officials have announced a series of steadily bigger lending programs for banks and Wall Street investment firms.
On Sunday, Fed officials agreed to lend up to $30 billion to JPMorgan Chase to engineer its takeover of Bear Stearns, a major Wall Street firm that was near collapse.
But Fed officials face increasingly contradictory pressures: inflation is rising even though growth has stalled.
The federal funds rate is once again edging close to zero, at which point the central bank would have to resort to entirely new strategies if it wants to keep opening its monetary spigots.
But a growing number of economists, including some Fed officials, contend that the housing bubble and downturn stemmed at least in part from the central bank's own decision to keep interest rates at rock-bottom lows from 2001 to the middle of 2004.
Meanwhile, consumer prices, even after excluding the prices of food and energy, are climbing faster than the central bank's unofficial target of less than 2 percent a year.

Courtesy: New York Times