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FED's Cut Short-Term Interest Rates - What Does It mean To You?

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FED's Cut Short-Term Interest Rates - What Does It mean To You?

For the first time in more than four years, the Federal Reserve has made it cheaper to borrow in Spetember 2007, and by an unexpectedly big margin by cutting the short-term rates 1/2%

The Fed surprised many economists and traders with a half percent cut in both the Fed Funds and Discount Rates. Stocks soared higher and enjoyed their largest gain since 2003.

What does the Fed cut mean? Rates on consumer debt, car loans, and Home Equity lines will all benefit. But because FIXED RATE Home Loan rates are tied more closely to investors' expectations of inflation, it is not uncommon to see less of a reaction...or even an opposite reaction in mortgage rates, they might fall a bit, they might rise a bit.

The Fed cut also hurts rates of return on investments, which gives foreign investors less incentive to invest in US securities. This has sent the Dollar much lower against the currency of most major foreign countries. This makes foreign goods more expensive for us to buy, which adds to inflation pressures.

Overall, the Fed cut is good news for the economy, but may nudge inflation a bit higher.

The central bank's rate-setting committee lowered the target for the federal funds rate by half a percentage point, to 4.75 percent. The prime rate will fall to 7.75 percent. Consumer interest rates based on the prime rate, mainly home equity lines of credit and most variable-rate credit cards, should fall a half-point in coming weeks.

Yields on certificates of deposit are likely to fall, too -- especially on shorter-term CDs -- even though they're not tied directly to the prime rate.

Everyone had expected a Fed rate cut, from investors and economists to teachers and car valets. The principal uncertainty had been about the size of the upcoming cut -- would it be a quarter of a percentage point, or half a point?

Most were expecting a smaller, quarter-point cut. The Fed sprung the surprise half-point decrease with this explanation:

"Economic growth was moderate during the first half of the year, but the tightening of credit conditions has the potential to intensify the housing correction and to restrain economic growth more generally. Today's action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time."

The committee added that inflation has been dropping, but that "some inflation risks remain."

This rate cut is intended to undo some of the damage caused by the housing bubble and the resulting credit crashes. The idea is to get people and businesses to buy on credit -- just not so recklessly this time.

Some economists and analysts worry that the Fed behaved recklessly with this half-point cut. A quarter-point decrease would have been preferable, they say.

Will the cut affect mortgages?
The biggest economic story of the year concerns housing: Home sales and average house prices have fallen nationwide, and it's harder to get jumbo and subprime mortgages. Lower mortgage rates might ease those troubles, but a Fed rate cut doesn't necessarily spell lower fixed-rate mortgages.

From Jan. 3, 2001, to June 25, 2003, the Federal Reserve cut the federal funds rate 13 times. When you look at what happened to the 30-year, fixed-rate mortgage in the month after each cut, here's what you find: Mortgage rates fell eight times and rose five times.

There is a huge amount of misperception among consumers that if the Fed reduces the rate half a point, my mortgage rates will go down too. Unfortunately, the media often adds to this confusion with bad reporting.

Remember, Long-term fixed mortgage rates go up and down mostly in response to investors' expectations of inflation, NOT what the Fed does.

This is the Federal Reserve's first rate decrease since June 25, 2003. Back then, the central bank worried that deflation might descend, crippling the economy, so the Federal Open Market Committee cut the federal funds rate to a 45-year low of 1 percent to fuel economic growth. The rate remained there for a year, and then the Fed raised short-term rates 17 meetings in a row, a quarter point at a time -- a gradual increase that took a little over two years. The target federal funds rate topped out at 5.25 percent in June 2006, and remained at that level until today's decrease.

In June 2003, the Fed justified its rate cut by invoking the specter of "an unwelcome substantial fall in inflation." The central bank succeeded in its aim of holding off catastrophic deflation. Indeed, the Fed did such a good job of suppressing deflation that it invited the opposite -- inflation -- but with a twist. Overall consumer prices remained under relative control, but prices of houses skyrocketed.

The fabled housing bubble occurred because the Fed made it cheap to borrow money. The federal funds rate was below 1.5 percent for 21 months. Mortgage rates were low, too. First-time and subprime homebuyers rushed in, driving up house prices. Subprime lenders, eager to make a buck, relaxed their underwriting standards. Meanwhile, from June 2004 to June 2006, the Fed was gradually raising rates.

Early this year, the double whammy of rising interest rates, plus poorly qualified borrowers, caused the subprime mortgage market to collapse. Millions of homeowners fell behind on their monthly house payments, leaving us where we are at today.

Comment balloon 1 commentJoseph Metzler • December 08 2007 08:30AM
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