TOPICS > Economy

Federal Reserve Cuts Interest Rates

September 18, 2007 at 6:10 PM EDT

RAY SUAREZ: Today’s Fed move was surprisingly aggressive. In a unanimous vote, members of the Federal Open Market Committee made two interest rate cuts. They slashed the federal funds rate by a half-point, lowering the rate banks charge each other to borrow money, and the central bank also reduced the discount rate by a half-point, as well. That’s the amount the Fed charges for direct loans to banks.

In a statement the Federal Reserve said, “The tightening of credit conditions has the potential to intensify the housing correction and to restrain economic growth more generally.”

For some analysis of the Fed’s action, we turn to Bill Cheney, chief economist at John Hancock Financial Services; and Philip Jefferson, a former Fed economist, he’s now a professor of economics at Swarthmore College.

And, Professor, were you surprised by the size of the rate cut?

PHILIP JEFFERSON, Former Fed Economist: I was surprised by the size of the rate cut, because what the Fed was trying to do here, I think, is, on the one hand, support the economy and make sure that the troubles in the financial market do not spread to the broader economy.

But at the same time, they were in a position where I thought it would have been important to also signal to financial markets that, if you find yourself in a difficult position because of lenient banking and lending practices, the Fed was not necessarily going to come in and clean up the mess afterwards.

And the size of this particular cut leads me to believe that the concern about the economy, combined with the desire to improve the balance sheets of financial institutions, really argued towards reducing the interest rate by 0.5 percent. And they were able to do that, also, because of the news about inflation, in that the outlook for inflation certainly was not severe at all, and so maybe they felt as though they had more room than market participants originally thought.

RAY SUAREZ: Bill Cheney, as we look at the economy overall, what was the state of play that made an interest rate cut necessary in the first place?

BILL CHENEY, Chief Economist, John Hancock Financial Services: I think the way I look at this is that the Federal Reserve, a couple of months ago, was primarily concerned about inflation when they thought that the economy looked as if it was on a pretty robust growth path. Two or three months later, the picture looks really different.

The housing market is weaker than we thought it was. The labor market has cooled off a bit. And then we have this sort of seizure in financial markets, which while I agree with your other guest that the Fed doesn’t care about the well-being of gamblers on Wall Street, they do care about the way that this phenomenon seems to have sort of locked up the credit channels in some ways and made certain parts of the market for credit that impinge on real people, businesses and consumer borrowers.

So the Fed now really wanted quite seriously to take out some insurance against the possibility that all these sources of weakness would add up to a real problem and head us into a recession. I don’t think they expected a recession, even if they did nothing, but it’s an important kind of insurance. And they had plenty of room to do it. The federal funds rate was high enough that this action really is more like taking your foot off the brakes. It’s not really giving the economy a whole lot of gas.

Effect of the rate cuts

RAY SUAREZ: Well, Bill Cheney, why don't you stay with us, and continue that thought, and tell us what the approximate effect is right away? These are two different rates, the rates that the Fed charges to banks and banks charge each other. How do they percolate through the economy when they drop? How is the effect felt?

BILL CHENEY: Well, the effect is felt on a wide range of short-term interest rates. It's felt even on the sort of troubled parts of the economy where people are reacting to adjustable rate mortgages. Those adjustable rates, in some cases, will move up a little bit less than they would have otherwise. If they adjusted already last year, maybe they'll be adjusting down a little now because of this.

But those impacts directly on consumers and business borrowers are probably really quite small. I think the bigger impact is really on the balance sheets of financial institutions, who are now looking at a bigger spread between their short-term cost of funds and their return to borrowing, to lending longer term, and on the overall psychology of the financial markets.

They've pushed out more money into the economy; that's what this amounts to. They've put more liquidity out there. And I think the financial markets are very much reassured that the Federal Reserve is on the job. You saw the result in the equity market today, took off like a shot. And I think the psychology in the short run is actually the bigger impact.

Longer term, yes, the channels of monetary policy work through making credit more available and a little cheaper across the board, but in the short run, it's more a psychology.

Market shoots up after announcement

RAY SUAREZ: Professor Jefferson, go ahead.

PHILIP JEFFERSON: Let me speak to that, because I think it's important to note that, at the time of the Fed announcement, the market was riding higher a little bit today, but then it shot up at the time of the Federal Reserve announcement. Now, in that surge, the largest component of that surge came in the stocks of firms in the financial sector.

So it is interesting to note that that was the sector that responded most favorably. And I think it's because investors realized that this, on impact, improved the financial outlook for those firms, by making some loans that were questionable now all of a sudden viable.

And why might that be the case? Well, the reason that would be the case is because the federal funds rate is closely related to the prime rate. And so now those variable rate mortgages that are key to the prime rate can be reduced. And it's possible that, by reducing that prime rate, we now can have households whose mortgage payments on adjustable rate mortgages may be $100 or less a month. And that certainly can make a big difference in not only improving the prospects for those households, but also in making loans that were heretofore or last night that were not performing all of a sudden much more viable and performing.

Accusations of a bailout

RAY SUAREZ: Bill Cheney, do you agree that this rate cut makes unviable loans more viable and perhaps shores up people who had been speculators? Some people have called this rate cut a bailout.

BILL CHENEY: I think it's a stretch to call it a bailout, and I really believe that the Federal Reserve truly has no interest in bailing out investors who make risky bets. But I think the reality is that, in the course of taking measures which will, in fact, sort of loosen up the financial markets and give a little boost to the economy, there's no way that they can help making life a little easier for the people who are real stretched on their investments, who had made bets that were a little bit too risky.

The people who really went out on a limb have already gone bust. And that's what's supposed to happen in financial markets. You make risky bets; sometimes you lose them. And the Fed isn't there to take care of that problem, but there is this issue that, in the course of stabilizing the economy and financial markets, maybe they make life a little bit too easy for some people. And I think that's the trade-off that they just have to make.

Possibility of more cuts

RAY SUAREZ: And very quickly, Bill Cheney, do you think more cuts are on the way?

BILL CHENEY: I would say not. I think the economy is likely to evolve just fine. And by October, the Fed will decide it doesn't need to move again.

RAY SUAREZ: And, Professor Jefferson, same question to you. Do you think more cuts are on the way in three months' time?

PHILIP JEFFERSON: Well, I think now that they have gone a 0.5 percentage points that they will now step back and see how the economy plays out. And I think that they will hold it steady there.

RAY SUAREZ: Professor Jefferson, Bill Cheney, gentlemen, thank you, both.


BILL CHENEY: Thank you.