Fed and Other Central Banks Lower Rates. Will It Help?

Today the US Federal Reserve, the European Central Bank and four other central banks lowered their rates with unprecedented coordination. The question is, will it work?

Today the US Federal Reserve, the European Central Bank and the central banks of the U.K., Canada, Sweden and Switzerland lowered their rates to help prevent a further detarioration in the credit and equities market.  The stock market responded with a 200 point loss in the Dow and an 11 point loss in the S&P 500.

The US Federal Reserve cut interest rates by 50 basis points to 1.5%.  BestCashCow savers will not be happy as banks have already begun to reduce the rates they pay on savings, cds, and money market accounts.  This clearly punishes savers, but will it help the econonomy.  Will the rate cut be effective?

It may lift equities for some time.  Rate decreases tend to make equities more attractive and while the Dow was down over 500 points this morning, it only finished down 200 for the day after the cuts were announced.  It may also help mortgage holders with adustastable rate mortgages since rates are pegged to the Fed Funds rate.

And, it will make it less costly for banks to borrow from each other, assuming they want to lend in the first place.

And that's the pitfall of cutting rates.  Banks have a giant hole in their balance sheets because of their bad mortgage loans and investments.  They are sitting scared, afraid to lend out capital for fear their depositors will come knocking, looking to withdraw money.  If enough depositors withdraw money, and the banks don't have the capital, then they go belly-up as we saw with WaMu, Wachovia, Indymac, etc.

Lowering the Fed Funds rate doesn't solve that hole.  The $700 billion bailout starts to do that but markets have said it's not enough. 

The rate cut is intended to inspire confidence and to get the wheels moving again.  But in a massive traffic jam, even if you turn all the lights to green, no one can move. 

Japan went through a similar situation in the 1990s and dropped its central bank rate to 0.  Even with the rate at 0, the banks that had been damanged in the country's massive housing bubble refused to lend.  It ook over ten years before Japan began moving again.

I fear that savers took it on the chin today and that we will see little benefit from these rate cuts. 

Sam Cass
Sam Cass: Sam Cass, MBA, JD, University of Texas at Austin. Always a fan of Leonardo Da Vinci.

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