6 Things to Know About the Fed Rate Cut

The Federal Reserve on Tuesday cut its federal funds target rate by more than three-quarters of a percentage point to a range of between 0 and .25 percent. The decision signals that Fed Chief Ben Bernanke is more concerned with the rapidly deteriorating economy--which has been mired in a recession since December of last year--than the prospect of stoking inflation. “Since the Committee's last meeting, labor market conditions have deteriorated, and the available data indicate that consumer spending, business investment, and industrial production have declined,” the rate-setting Federal Open Market Committee said in its statement. “Financial markets remain quite strained and credit conditions tight.”

Here’s how the Fed’s actions affect you:

1. Fixed mortgage rates: Today’s rate cut will have little if any impact on 30-year fixed mortgage rates, which are determined by factors that operate largely outside of the Federal Open Market Committee’s reach, says Keith Gumbinger of HSH Associates. “Any change in the rate has little to do with long-term mortgage rates,” he says. But in its statement the Fed said it could expand a recently announced program to buy up debt and mortgage-backed securities from Fannie Mae and Freddie Mac that has already driven mortgage rates down to a very attractive 5.28 percent, according to HSH Associates. It also reiterated that it was looking at the possibility of buying long-term Treasury bonds. Both of these announcements could work to bring rates even lower.

2. Prime rate: The real impact of today's cut will be felt by consumers with products that are tied to the prime rate, a benchmark rate that typically moves in lock step with the federal funds rate. "The only place where you would see a concrete impact at the consumer level would be things that are directly tied to prime," says Mike Larson, a real estate analyst at Weiss Research. Many home-equity lines of credit and certain credit cards with variable interest rates are tied to prime rate. As such, borrowers with these products could see their interest rates decline.

3. Home-equity savings: Home-equity lines of credit averaged 5.5 percent in October but dropped to 5.26 percent in November following the Fed's half-point cut. Gumbinger says he expects average rates on home-equity lines of credit to experience similar declines this time around--but not everyone will be able to take advantage of them. That's because many of the interest rates on these products are already at their minimums and are contractually prohibited to go any lower. So check the terms of your home-equity line of credit to see if you are eligible to cash in on the decline.

4. Target vs. effective: When credit markets are functioning normally, Fed rate cuts reduce banks’ cost of funding, which allows them to widen profit margins and pass along savings to consumers in the form of lower interest rates. But today’s credit conditions have changed all that. Although the Fed’s target rate stood at 1 percent before today’s cut, such funds were actually being traded in the market at much less than that--just 0.18 percent as of yesterday before the Fed’s action. Although the Fed can usually control the effective rate by buying and selling government securities, the credit crisis has eroded its ability to do so. “Any juice that you would get from a funds rate cut in a normally functioning market, you’re not really going to get that here,” Larson says. “It’s not going to lower the banking industry’s cost of funds, because the banking industry’s cost of funds is already below the target rate anyway.” That means that interest rates tied to the federal funds rate won’t decline as much as they otherwise would have.

5. Now what? Nariman Behravesh, chief economist at IHS Global Insight, expects rates to go all the way to zero in a matter of weeks. “The Fed has already cut the federal funds rate to 1 percent and is likely to take it all the way to zero by the end of January,” Behravesh said in a recent report, issued before today’s announcement. “Once the overnight rate is at zero, the Fed may have to engage in ‘quantitative easing’ [direct purchases of long-term Treasuries].” Even if it doesn’t bring rates all the way to zero, the Fed signaled Tuesday that it’s not about to push rates higher anytime soon. “The Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time,” the Fed said in the statement.

6. Expect more unexpectedness. With only less than a quarter of a percentage point left to cut, look for the Fed to get even more creative in its efforts to revive the financial markets. New programs to support different corners of the credit market could certainly be introduced in 2009. “The Federal Reserve will continue to consider ways of using its balance sheet to further support credit markets and economic activity,” the Fed said in the statement.

Corrected on 12/17/08: An earlier version of this article incorrectly referred to home-equity lines of credit as home-equity loans.