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What does the fed rate cut mean?

August 17th, 2007 12:04 PM

Today (08/17/2007), in an unprecedented move, the Federal Reserve made an
emergency Discount Rate cut of .50% (1/2 percent) in order to attempt to
avert further liquidity crisis (cash shortage) in the banking industry.

This does not mean that mortgage rates have been cut.

And this is not the same thing as a Fed Funds rate cut. There is an
important difference.

In order to understand what this means, you need to know a few basic
definitions:

The Federal Reserve banks’ primary responsibility is to ensure that
fluctuations in the demand for cash does not disrupt the banking
industry

Fed Discount Rate: The interest rate at which eligible banks may
borrow funds, usually for short periods, directly from a Federal
Reserve Bank – this is to meet temporary shortages of liquidity
caused by internal or external disruptions (also known as the
Discount Window)

The Discount Rate has very little to do with how retail interest rates
ultimately affect consumers of loans and credit, but rather primarily
affects the internal stability of the banking industry

Fed Funds Rate: The interest rate at which non-Federal Reserve banks
lends immediately available funds to other non-Federal Reserve banks
overnight (Also known as the Overnight Lending Rate)

The Fed Funds rate is the one that is adjusted to increase growth or
moderate inflation of our overall economy. This usually has a direct effect
on the 10 Year Treasury Bill, which is the primary driver of mortgage
rates. A Fed Funds rate change has a significant impact on retail interest
rates.

In summary, it would be a mistake to assume that because the Fed Discount
Rate has been lowered to help the banks avoid a cash crunch meltdown, that
mortgage rates will either drop or go up. This is because the primary Fed
Funds Rate has not been revised.

In fact, it is just as likely that as the stock market recovers, mortgage
rates are more likely to go up than down! This is because bonds will get
sold, which raises the yields and therefore mortgage rates.

Any impact of this Discount Rate cut remains to be seen and will only play
out in a macro-economic, long term way via restored confidence and
liquidity of the banking industry.

PM

Posted by Peter Mansolillo on August 17th, 2007 12:04 PMPost a Comment (0)

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