Federal Reserve Rate Cut: What Does It Mean?

The country's top monetary policymakers took a somewhat unusual step in trimming the discount rate. We explain what it does -- and doesn't mean.

By Jerome Idaszak, Associate Editor, The Kiplinger Letter

August 17, 2007

The Federal Reserve's move to cut a half-point from the discount rate will go some distance in soothing financial markets roiled by problems in housing and subprime mortgages. But the Fed's move is significant not only for what it did, but also for what it didn't do -- cutting the federal funds rate, which has a direct impact on interest rates paid by businesses and individuals. To help you decipher what's going on, we've put together some questions and answers.

Q. What exactly does cutting the discount rate do?

A. To keep credit markets liquid -- making sure that money is available for lending when and where it's needed -- banks routinely borrow from each other for very short periods. But they were having trouble doing so because few banks were willing to accept as collateral any securities backed by mortgages. At the same time, the $2-trillion commercial paper market -- debt backed by businesses -- was also freezing up. Keeping the credit market flowing is essential; without it, economic growth would grind to a halt.

So the Fed is oiling the machinery. Banks can borrow not only from one another, but directly from the Federal Reserve, through what is called the discount window. Typically, banks don't do so, though, because the rate is well above what they usually pay to each other, and in the past, there had been a bit of a stigma to borrowing from the Fed: It was usually the lender of last resort for banks in trouble.

By lowering the discount rate and lengthening the loan terms from the usual one day to 30 days, the Fed is making sure that banks know they have someplace to go. And it's making borrowing from the discount window more attractive -- or at least less unattractive. The new discount rate of 5.75% is still higher than the 5.25% bank-to-bank lending rate, but the Fed will accept high-quality mortgage securities as collateral.

Q. Why didn't the Fed just cut the federal funds rate as it more typically does when it wants to stimulate the economy?

A. Two reasons: First, the Fed isn't convinced that the economy needs stimulating, and the monetary policymakers' long-term concerns about inflation haven't evaporated. The Fed does want to make sure that what it sees as a short-term bottleneck in the credit markets doesn't turn into a much bigger problem. If creditworthy households and companies can't get needed loans, a recession would surely follow. Thus, as the Fed's statement indicates "downside risks to growth have increased appreciably."

And second, the Fed doesn't want to bail out investors who made risky choices by just keeping the music going.

Q. Will the Fed's action make a difference?

A. It should. Financial markets function on a foundation of confidence and trust. With doubt about the solvency of mortgage makers such as Countrywide Financial Corp. and even big investment firms such as Bear Stearns spreading in recent days, the Fed was seeing the opposite of the irrational exuberance of the late 1990s and early 2000s: irrational paranoia. Its actions and words are aimed at restoring confidence and order.

Money should flow more easily again. With the Fed lending funds to banks and accepting good-quality mortgage securities as collateral, other lenders will be encouraged to do the same.

Q. Can we expect the Fed to take additional steps?

A. If the situation continues to worsen, additional action would be needed and will be taken. It remains to be seen if big losses in investments and old mortgage and junk-bond-related loans will topple several big investment banks or lenders. If that happens and/or if the economy shows signs of a sharp slowdown over the next month, the Fed will almost certainly cut short-term interest rates by slashing the federal funds rate at the Federal Open Market Committee meeting on Sept. 18.

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