Federal Reserve Cuts Federal Funds Rate by ¾%

Yesterday, the Federal Reserve Open Market Committee (FOMC or Fed)) voted to cut the Federal Funds Rate by .75% to 2.25% - the sixth time they cut rates in the past six months. These rate cuts are meant to stimulate the economy by making it cheaper for banks to borrow and lend money and for business to borrow to grow their business. This time, there was a lot of differing opinions on how large the rate cut would be. Some looked for the FOMC to cut by a full 1% while others were looking for only a .5% cut. The vote by the Fed was not unanimous – two members felt the cuts were too aggressive given the threat of inflation.

Cutting interest rates can be seen as inflationary. It stimulates the economy and also devalues the US dollar in relation to other currencies. This causes prices we pay to increase in the future and, as a result, many long-term interest rates, such as mortgages, actually increase when the Fed cuts rates.

Some homeowners with mortgages that are tied to the Prime Rate will see a decrease in their interest rates on these loans since banks tie their Prime Rate to the Federal Funds Rate – when the Fed cuts by .75%, banks cut their Prime by .75%. Usually, Home Equity Lines of Credit are based on the prime rate. These homeowners should see the new rates reflected on their next statement.

These rate cuts don’t seem to be working, the economy is still heading for recession

When the Fed cuts rates, it can take 6 – 9 months before they have an impact on the economy. Therefore, the economy is just now experiencing the rate cuts that the Fed put into effect when they began cutting rates in September 2007. The Fed tries to get in front of problems so they can prevent or lessen upcoming problems. The economy continued to grow through the end of 2007 and now the cuts are helping to prevent the economy from slowing further.

And what about mortgage interest rates?

This is an even more complicated question. The mortgage market is affected by the economy and, to some degree, the actions by the Fed. But, as I mentioned before, these rate cuts can be inflationary which will tend to increase mortgage rates. In addition to the economy, the mortgage rates are affected by the sub-prime mortgage crisis, the slowing housing market, and the resistance of investors to purchase the mortgage-backed securities (MBS) that fuel the mortgage market.

Today (3/19/08) the Office of Federal Housing Enterprise Oversight(OFHEO), the regulators for Fannie Mae and Freddie Mac, took a huge step today to increase the liquidity (Availability and accessibility of mortgage funds) of the mortgage market. The steps they took today will allow Fannie Mae and Freddie Mac to provide up to $200 billion in mortgage-backed securities liquidity. By purchasing these MBS, Fannie Mae and Freddie Mac will make a significant dent in the logjam of mortgages that have been unable to be securitized and purchased over the past several months. This logjam has led to MBS being less attractive and a widening of the spread between the yield on mortgages and US Treasury bills, notes, and bonds. This should increase the demand for MBS thus raising their prices and lowering their yields – this will in turn lower mortgage rates.