The Fed Steps Up With a Rate Cut
The Federal Reserve is finally getting with the program—and investors couldn't be happier.
The Fed's decision Friday to lower the so-called discount rate it charges for short-term loans to banks to 5.75 percent (a half-percentage-point cut from where it's been for the past 15 months) won't have any direct effect on the interest rates homeowners pay for their mortgages. But it could help keep mortgage lenders now teetering on the edge of insolvency from going out of business.
Unlike the more important fed funds rate, which provides a target rate for hundreds of billions of dollars in short-term lending between banks and strongly influences consumer loan rates, the discount rate is a seldom-used and largely stigmatized funding device that allows banks—usually distressed ones—to borrow cash directly from the Fed at a rate that's generally a full percentage point above its market-linked counterpart. The Fed's discount window usually lends only a tiny fraction of the volume of dollars linked to the fed funds rate.
Yet, as with many Fed decisions, words are often more powerful than numbers. And by acknowledging that "the downside risks to growth have increased appreciably" and conspicuously leaving out any mention of inflation, the Fed all but reassured the markets that a cut in the fed funds rate is now on the table, perhaps as soon as at the Fed's next meeting in September.
That's a sharp departure from the recent past, when the Fed has held the rate steady. St. Louis Federal Reserve Bank President William Poole argued earlier this week that nothing short of a "calamity" would push the Fed to act before its next scheduled meeting. Even then, Poole said the Fed would have to "decide whether to share that view" that the economy was in enough trouble to warrant a rate cut.
Indeed, despite pumping tens of billions of dollars into the banking system to help keep the fed funds rate down near its 5.25 percent target, until Friday the rate-setting agency had been unwilling to officially put the threat of an economic downturn above that of runaway inflation. As the credit crunch has worsened, the Fed's seeming intransigence had led some on Wall Street to claim that its board of governors was asleep at the wheel and "have no idea" just how bad things are, as CNBC's Jim Cramer screamed during a segment that has since been downloaded on YouTube more than 2 million times.
Unless the Fed acts—and quickly—he and others have predicted the demise of big mortgage lenders like Countrywide Financial, where panicked depositors lined up to withdraw their money on Thursday despite CEO Angelo Mozilo's reassurances that the company had plenty of money to weather the storm. Indeed, Cramer warned viewers of his Mad Money show on Thursday that the Fed, in fact, had it in for lenders like Countrywide, Washington Mutual, and IndyMac, which have been widely seen as having helped worsen the recent housing debacle through lax lending standards that put too many buyers into homes they couldn't afford.
But by giving companies like Countrywide a better backstop today, the Fed reaffirmed that it's not in the business of targeting companies for elimination. Rather, it's here to help make sure the banking system works when it has to.
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