The Federal Reserve Board responded to the economy yesterday by lowering the target for the federal funds rate to 1% and the discount rate to 1.25%.
The first number is the rate usually in the news. The federal funds rate is the interest rate that banks charge to lend their balances to one another. If one bank wants to loan $30m to another bank, the two companies can negotiate the rate and the lending back and charge the borrowing back the rate agreed upon. By lowering the federal funds rate target, the Fed is saying they’d like to see this interest rate around 1%. The true lending interest rate is controlled by the market, guided by the Fed.
When banks borrow money from the Federal Reserve, the discount rate serves as the interest rate for the loan.
The federal funds target rate hasn’t been as low as 1% since June 29, 2004, having reached that level over a year before on June 25, 2003. A low target rate, and the ensuing availability of easy credit, possibly contributed to today’s credit crisis. But today’s low target rate will have a different effect, according to the policy makers. They believe low rates will increase liquidity between banks and encourage more — but sensible — consumer lending.
It might not be enough. Here’s the important part of the Federal Reserve’s statement yesterday:
Recent policy actions, including today’s rate reduction, coordinated interest rate cuts by central banks, extraordinary liquidity measures, and official steps to strengthen financial systems, should help over time to improve credit conditions and promote a return to moderate economic growth. Nevertheless, downside risks to growth remain. The Committee will monitor economic and financial developments carefully and will act as needed to promote sustainable economic growth and price stability.
“Downside risks” and “will act as needed” probably signal more rate cuts to come in the future. But there isn’t much further you can go from here. The Federal Reserve could cut the target rate to 0%, but that would be a first, I believe. If banks still aren’t lending to each other at that point, the only other option is simply printing money.
Inflation would increase, making it more difficult to afford the same living standards unless inflation is accompanied by growth in salaries. The current jobs market doesn’t make salary growth seem likely.
So what does this mean for me?
The moves by the Federal Reserve don’t affect interest rates on consumer loans. Rates on long-term mortgages will not change dramatically due to changes in the federal funds rate or the discount rate. Adjustable rate mortgages might see a decrease in interest rates. Many ARMs are tied to a different rate entirely, the LIBOR. The LIBOR has been slowly decreasing, as well.
Savers are in for bad news. Interest rates offered by banks for savings account usually follow the movements of the federal funds target rate, but some banks may follow the LIBOR movements. A number of banks have decreased their interest rates recently, and I expect that to continue.
Published or updated October 30, 2008.