What the Fed’s Shift in Interest Rate Policy May Mean

The Federal Reserve signaled Tuesday that it is ready to cut its official interest rate in 2001 if the economy continues to slow. A move to cut rates would, of course, have major implications for investors, savers, consumers and businesses.

Here are answers to some of the common questions posed by a shift in the Fed’s interest rate policy:

Q: Is there any indication how sharply the Fed might cut rates?

A: Publicly, the Fed never gets that specific about its plans. However, 24 of 26 major Treasury bond dealers polled Tuesday by Reuters said they expect the Fed to cut the target for its benchmark short-term rate to 6.25% at the central bank’s Jan. 30-31 meeting, from the current 6.50%.

Futures contracts that are based on the Fed’s short-term rate (which is the federal funds rate, the overnight loan rate among banks) now appear to be pricing in a half-point rate cut by April.

But everything depends on the economy: If it continues to slow sharply early in 2001, the Fed could act much faster, and with deeper cuts.

Q: When the Fed begins to cut rates, does it usually continue to do so for some time?

A: Again, that depends on the economy. From mid-1989 to September 1992, the Fed cut its key rate 24 times, reducing it from 9.50% to 3%. But that encompassed the recession of 1990-91 and its aftermath, when doubts lingered about the economy’s ability to sustain a recovery.

Since the mid-1990s the Fed has done a lot of “fine tuning” with rates. After doubling the fed funds rate from 3% to 6% in 1994-95 to brake a speeding economy, the Fed turned around and made three 0.25-point cuts in the rate from mid-1995 to early 1996.

That was followed by a 0.25-point increase in March 1997. The Fed then held steady until the fall of 1998, when the global financial system was rocked by Russia’s debt default. The Fed made three successive 0.25-point cuts in its rate in September, October and November of 1998.

Q: How high is the Fed’s rate today, historically speaking?

A: At 6.5%, the fed funds rate is the highest since 1989, thanks to six rate hikes from mid-1999 to last May. In theory, at least, that gives the Fed a lot of leeway to reduce rates to bolster the economy.

Q: Is there any reason to think the Fed could cut its rate back to 3%, where it was in the early 1990s?

A: Few economists currently see rates falling that dramatically, barring a severe recession.

Analysts point out that a major reason the Fed kept rates so low in the early ‘90s was to revitalize the banking system. Many banks were reeling from bad loans, especially in the real estate sector.

By keeping short-term rates so low, the Fed allowed the banks to borrow very cheaply short-term and invest that money in higher-yielding, longer-term Treasury bonds--earning hefty profits on the difference between their cost of money and what they earned on the bonds.

This time around, many Wall Street analysts don’t expect the banking system to need that kind of help, even if the economy slows further or enters a mild recession.

What’s more, the Fed is most sensitive to inflation, which by some measures has been creeping higher this year, in part because of soaring energy costs. If inflation continues to rise in 2001, the Fed will be much more reluctant to cut interest rates significantly.

Q: Will other interest rates fall if the Fed in fact begins to cut its official rate?

A: Many market interest rates have already come down sharply this year, anticipating a weaker economy and eventual Fed rate cuts.

For example, the yield on the two-year U.S. Treasury note has fallen to 5.34% as of Tuesday from 6.36% at the end of June. The 10-year T-note yield has fallen to 5.18% from 6.03% at the end of June.

Also, mortgage rates--which take their cue from the Treasury market--have slid to their lowest levels in 18 months.

Thus, it isn’t clear how much more those yields can fall, especially if the Fed reduces its official rate only once or twice next year, then holds steady because the economy appears to be reviving.

But other rates would indeed fall if the Fed cuts its rate. The prime lending rate, for example, generally moves in tandem with the federal funds rate. The prime, now at 9.5%, is a peg used to set other consumer and business rates, including rates on many home equity loans.

Likewise, yields on the short-term government and corporate IOUs that money market mutual funds buy would fall with any Fed cuts. Bank certificate of deposit yields and other shorter-term savings rates have been easing in recent weeks and would be expected to slide faster if the Fed begins to ease its rate.

Market interest rates, like the Fed itself, now will take their cue from the economic data over the next few weeks: If the economy appears to be spiraling toward recession, Treasury yields and other rates are likely to continue dropping, and the political pressure on the Fed to signal meaningful rate cuts in 2001 would mount.

All of this means Fed Chairman Alan Greenspan’s words between now and late January will carry even more weight than usual.

“Financial markets will pay close attention to every utterance of Chairman Greenspan for a possible hint that he might cut the interest rate more aggressively than a quarter-point in January,” said economist Sung Won Sohn at Wells Fargo.

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Markets: Ahead of the Fed

Yields on Treasury bonds have already fallen sharply this year, as investors bet on a slowing economy. Mortgage rates have been pulled lower with Treasury yields. But yields on corporate junk bonds remain at high levels, reflecting fear of a sinking economy and more bond defaults.

Source: Bloomberg News, Freddie Mac, KDP Investment Advisors