The Federal Reserve Open Market Committee (FOMC) today slashed 50 more basis points off its target for the federal funds rate, the rate that banks charge each other for overnight loans. This is the tenth cut this year, bringing the benchmark to 2%, the lowest level since 1961. The FOMC also reduced the discount rate 50 basis points to 1.5%.
The FOMC in its press release said in Fed-ese that it was still more concerned about economic weakness than inflation, and added, "Although the necessary reallocation of resources to enhance security may restrain advances in productivity for a time, the long-term prospects for productivity growth and the economy remain favorable and should become evident once the unusual forces restraining demand abate."
Despite all the attention paid to the Fed, Chairman Alan Greenspan and his band of merry people can only affect the economy in a specific, limited, and indirect way. By lowering the target for the federal funds rate, the Fed seeks to decrease a bank's cost of funds. This increases the spread between what it pays for money and what it can charge in loans to borrowers. The Fed hopes that by creating the conditions to improve banks' profitability and encourage more lending, banks will be better able to deal with an increase in loan defaults and businesses will borrow to invest in capital expenditures and improve the economy.
With the consumer price index measure of inflation most recently at 2.6%, banks have been able to borrow essentially for free since October's rate cut to 2.5%. But no matter how favorable conditions are for banks to borrow and lend, many businesses have overspent to build capacity in the last few years and are not clamoring to borrow more.
The FOMC rate cut may bring more good news to individual homebuyers and homeowners. While not directly linked with mortgage interest rates, a lower federal funds rate may lead to lower home mortgage rates if it coincides with lower long-term inflation expectations. When mortgage rates decline, renters may find home-buying more affordable, and homeowners may be able to save money through refinancing their mortgages to obtain a smaller monthly payment. (The Fool's got all the worksheets and calculators to help you with every part of home-buying and refinancing.)
If you're curious about the how the Fed operates, enjoy our riveting feature on The Federal Reserve. You can also find the intended federal funds rates since 1990 on the Federal Reserve's website.
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