Federal Reserve Rates Cut - In A Nutshell
The Federal Reserve’s rate-setting Open Market Committee cut the target for the federal funds rate half a percentage point, to 4.75 percent.
Economic growth was moderate during the first half of the year. But it’s harder for consumers and corporations to get credit now, and possibly intensifying the slowdown in home sales and the slide in housing costs. Cutting rates is intended to keep the credit crunch from spilling over into the broader economy and to stimulate the overall economy.
Inflation has grown tamer this year. But there’s a risk that inflation will kick it up a notch. The Fed will keep an eye on that.
It’s not only harder for consumers to get jumbo and subprime mortgages, corporations are having to work harder to find short-term debt. Hedge funds and other money managers are afraid to buy and sell mortgage debt, because if they do so, their theoretical losses will become actual losses. In short, credit is harder to come by, and that makes the economic outlook uncertain. The Fed will keep an eye on that, too.
Seven of the 12 Federal Reserve Banks suggested lowering the discount rate, which is what member banks pay the Fed for short-term loans. Cuts in the discount rate used to be more symbolic than substantive, because banks rarely borrowed at the discount window. It was seen as unseemly. But as credit dried up over the summer, the Fed encouraged banks to borrow directly from the central bank via the discount window, and emphasized that there’s nothing dishonorable about it. Banks have borrowed billions of dollars via the discount window in recent weeks.
What does this mean?
Adjustable-rate mortgages - ARMs are sensitive to Fed rate changes
- Rates on ARMs are primarily tied to short-term indexes, such as LIBOR, the one-year Treasury or the 11th District Cost of Funds. The one-year Treasury and the LIBOR tend to pretty quickly follow moves in the federal funds rate; the Cost of Funds lags a bit.
- As the Fed boosts or cuts short-term rates, ARMs are far more sensitive after the fact than fixed-rate mortgages.
Fixed-rate mortgages — not much effect
- Fixed mortgage rates aren’t directly tied to Fed interest rate moves. Instead, they’re closely tied to long-term government bond yields, such as the 10-year Treasury, which tend to move in accordance with the economic outlook and in advance of moves by the Fed.
Who benefits?
- ARM holder or shoppers as adjustable-rate mortgages are likely to go down.
- Fixed-rate shoppers — as investors became convinced that the Fed would cut short-term rates, fixed-rate mortgages fell. Now that the Fed has cut the federal funds rate even more than expected, fixed-rate mortgages should remain low and perhaps fall further.
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