What Do Interest Rate Cuts Mean?

The cuts by Greenspan and the Federal Open Market Committee — the committee that makes decisions concerning the Federal Reserve Board's operations — has a big effect not just on investors, but on consumers as well. In fact, they place a big, bold stamp on everything from stock market performance to home mortgages to savings account rates.

HOW RATE CUTS AFFECT YOU

Let's look at stocks first, where an interest rate cut has the most immediate effect. On April 18, 2001, the Fed cut rates by one-half of a percentage point. The Dow Jones Industrial Average (DJIA), the bellwether index for traditional, old-economy stocks such as IBM, Ford, and Procter & Gamble, rose by 3.9% in just one day. The Nasdaq stock market, where many of the information technology company stocks are traded, fared even better, rising 8.9%.

Financial markets respond favorably to interest rate cuts because, in effect, they make the price of money cheaper. Rate cuts trigger a chain reaction of bank interest rate reductions and other events that ultimately mean banks have more money to lend and are willing to charge less for it. That affects everything from consumer credit cards to small-business equipment loans to corporate bonds. Interest rates also affect companies that have loads of cash but don't need to borrow. The lower rates go, the less attractive it becomes for these companies to let their money sit in the bank, rather than use it to hire 500 new employees or expand into new markets.

Longer term, the Federal Reserve cuts interest rates to help thwart a recession, which is a downturn in the economy where negative growth occurs in the US Gross Domestic Product (GDP) two quarters in a row. With the September 11, 2001, terrorist attacks, recession clouds gathering in the form of high oil prices, a tight labor market, an overvalued stock market, a spike in the private-sector debt level, and a bank and investment credit crunch suggest we're already in a full-blown recession. Historically, no one or two of these factors alone have meant that the United States was heading into a recession. But seldom have so many danger signals converged at the same time.

INTEREST RATE MOTIVATORS

A potpourri of investment and economic factors form to move interest rates one way or another. Of those factors, the performance of the US bond market is perhaps at the top of the list. Generally, mortgage interest rates move in tandem with interest rate movements. Consequently, banks use formulas to determine interest rates based on the bond market's daily movement.

When the Federal Reserve changes its prime lending rate to attack such economical ills as inflation, banks also change their lending rates. Rates may also rise if there is more demand for home loans (and rates may go down if there is less demand for homes and home loans). Higher rates can spur on-the-fence borrowers to make a quick purchase decision. When the economy is slow, consumers don't borrow as much, perhaps leading to lower interest rates. When the economy is booming, demand for borrowed funds increases, leading to higher interest rates.

MORE MANAGEABLE MORTGAGES

Recession fears aside, consumers welcome interest rate cuts for other reasons that hit close to home. A cut in the federal funds rate, for example, means the nation's banks will likely cut their prime rates, which are tied to consumer lending for such items as homes and installment loans. When the Fed cuts rates, banks usually follow by lowering the prime rate, the benchmark that many lenders use when making auto loans or home-equity loans to customers. Homeowners, particularly those with an adjustable rate mortgage (ARM), are the most likely group to benefit from the Fed's move as interest rates are reduced. Since ARMs are tied to a variety of short-term indexes such as Treasury bills and notes, they are affected even more directly by a Fed move.

On top of mortgage rates, other loan rates such as home equity, credit cards, and small business could all be nudged down, which is more good news for consumers. The cut is not without drawbacks, however. Because most banks use the prime rate as the basis for the interest rates they pay on savings accounts, certificates of deposit (CDs), and money market funds, consumers may get less in interest income from those sources.

The effect of an interest rate cut on savings also comes into play. Lower interest rates tend to discourage people from saving. Rates of returns on bonds, for example, tend to slide after a rate cut. Lack of consumer savings can create a shortage of funds for banks to lend to firms for investment. That was the reason, among others, that President Bush decided to encourage savings in his recently passed tax package by offering expanded tax advantages in the form of expanded 401(k) and Individual Retirement Account (IRA) ceilings up to $15,000 from $10,000 on the former and up to $5,000 from $2,200 on the latter.

Interest rates cuts can be beneficial, both in the financial markets and in the prices that consumers pay for gasoline, cars, and other goods. Those rate cuts may take time to sink in, but they are usually worth the wait.

Brian O'Connell is a Philadelphia-based freelance financial writer. His most recent book is CNBC Creating Wealth. He can be reached at briano@tradenet.net.

Current and past articles from Working Money, The Investors' Magazine, can be found at Working-Money.com.