Fed’s short-term rate cuts fuel stock market rally

Actions not expected to help long-term mortgage rates

By Matt Carter, Tuesday, March 18, 2008.   The Federal Reserve today cut 75 basis points from two key short-term interest rates — a move that in less turbulent times would have been viewed as a drastic measure, but which fell short of some investors’ expectations for a full 1 percent cut.

 The Fed’s actions fueled a stock market rally, but aren’t expected to have an impact on long-term interest rates like mortgages until investors who fund loans return to the secondary market where they are bought and sold.

 The decision by the Fed’s Open Market Committee to lower its target for the federal funds overnight rate from 3 percent to 2.25 percent — and to cut the discount rate to 2.5 percent — makes money available more cheaply to banks and financial institutions.

 The Fed has now cut its target for the federal funds rate — the rate banks charge each other to lend money overnight — six times since September, when it stood at 5.25 percent.

 In a statement, the committee said that financial markets “remain under considerable stress,” but that worries about inflation precluded an even larger, 100-basis-point reduction that some investors had been betting on. One basis point is a hundredth of a percent.

 “Inflation has been elevated, and some indicators of inflation expectations have risen,” the committee said. While inflation is expected to moderate in coming quarters, the committee warned that “it will be necessary to continue to monitor inflation developments carefully.”

 The committee’s inflation warning may have reduced expectations for future drastic cuts in short-term interest rates, and fears about inflation could translate into higher mortgage rates. But the Fed has introduced several other measures intended to provide liquidity to banks and financial institutions and help ease the credit crunch.

 Those measures include a new lending program announced Sunday that will allow investment banks to borrow billions using mortgage-backed securities as collateral, and twice-monthly auctions that provide another source of short-term loans .

 Mortgage Bankers Association Chief Economist Doug Duncan said today’s rate cut is not likely to have a direct effect on long-term interest rates such as mortgages, but will provide relief for borrowers with adjustable-rate mortgage (ARM) loans for which payments are scheduled to reset.

 “The steps the Federal Reserve is taking are all part of the almost unprecedented effort to provide liquidity to the broader financial markets in response to the growing illiquidity of securitized instruments,” Duncan said in a statement.

 Gus Faucher, director of macroeconomics at Moody’s Economy.com, said in an interview before the decision was announced that it would not make much difference whether the cut was 75 or 100 basis points.

 “Either number will grab a lot of attention, but it’s not very effective in the current environment — it’s going to take a lot more than rate cuts” to get financial markets functioning again, Faucher said.

 When the Fed lowers its targets for the federal funds rate, other short-term rates hardly budge, Faucher said, and when they do, there’s still little willingness to loan money anyway.

 Faucher, who believes the economy is in a recession that began in December, is convinced that the only way to restore confidence in financial markets is for the federal government to absorb losses in mortgage markets.

 Although Democrats have put forward several proposals for how the government might buy up mortgages headed for foreclosure at a discount from lenders — or create programs that would help the private sector accomplish the same thing — the Bush administration has not been receptive, saying it does not want to bail out speculators.

 Faucher thinks that if the Fed said, “We’re going to put some money on the table,” investors would be reassured, “and it could turn out to be the case that the government doesn’t need to actually spend that money.”

 Because they have had so little impact on lending or the economy itself, Faucher doesn’t see the Fed’s short-term interest-rate cuts as harmful, either.

Some observers worry that short-term rate cuts will weaken the dollar, push up the price of oil and other commodities, and fuel inflation — which would in turn drive up yields on long-term investments like Treasurys and mortgage-backed securities.

 So far, the short-term rate cuts — intended to grow the economy by encouraging businesses to borrow — are not having much impact on inflation, “because they are not having much impact on the economy,” Faucher said. “The Fed can cut, but if the lenders are not willing to lend it doesn’t make any difference.”

 That’s a view shared by the California Association of Realtors’ economist, Leslie Appleton-Young.

 “If people expect a lot of inflation in the future, that long rate is going to be higher,” Appleton-Young said. “The problem with the markets right now is they are not operating. This is just absolutely unprecedented. So if the Fed lowers (short-term rates), I think that’s great, they are trying to boost confidence.”