As I write, it is breaking news that the Fed has cut interest rates for the second time in less than 2 weeks. TheStreet.com reminds us these are the steepest cuts since 1982, bringing us to the lowest rates since 2005. From CNN:
The federal funds rate, an overnight bank lending rate that affects how much interest consumers pay on credit cards, home equity lines of credit and auto loans, was cut to 3.0% from 3.5%. The rate had stood at 5.5% only four months ago.
The discount rate, which is what banks pay to borrow directly from the Fed, was also cut by a half-percentage point to 3.5% on Wednesday.
By way of review, The Fed does not control the “Prime Rate,” but rather two interest rates that influence what that rate is. Remember that scene in It’s a Wonderful Life where Mr. Bailey is explaining that the money isn’t there in the bank, but rather is lent out to people to do things like build houses and start businesses? Well, banks still have to keep a certain amount of money in the bank. Sometimes they run short, so they borrow from another bank at the “overnight” rate — controlled by the Fed. Sometimes other banks don’t have the money to lend, so they borrow from the Fed itself at the “discount” rate.
When these key interest rates are lower, it encourages banks to lend more money at lower interest rates, because it is cheaper for them to borrow money. This theoretically stimulates the economy, because it means more money is available for people to buy (or refinance) homes or make business investments. I say theoretically, because I have come to the rather unorthodox conclusion that there is a bottom level below which this does not necessarily hold true based on our experience here in the United States several years ago and the experience of Japan over the last decade.
One thing I would like to make clear: Wall Street thinks that this is a Good Thing. They see this as meaning that the Fed is on top of things and will do whatever it takes to avoid recession. I see the fact that they had to take this cut — after last week’s large cut — as a sign that things are not very good at all. It means the economy is in bad enough shape that they did not feel comfortable letting that cut work its way through the system. It means they are nervous about the fact that GDP growth — a shorthand way of looking at our economic output — slowed to 0.6% last quarter.