Following today’s Federal Reserve interest rate cut, many are wondering if the United States Central Bank has moved too quickly to reduce the benchmark interest rate that it charges to banks.  Others were hoping for an even more dramatic move of a half-point reduction instead of the quarter-point decrease. 

After a period of silence following a methodical increase in interest rates designed to slow a once rapidly growing economy, the Fed has moved three times now in the last few months to lower the federal reserve interest rate a combined one percent, in order to offset an economy that had slowed faster than hoped.  Most importantly, the move has been a drastic response to the struggling mortgage and housing markets.

Washington Mutual just announced significant layoffs and office closings yesterday (December 10), a sign that many are still struggling with the housing slump and the record foreclosures and delinquent credit payments by homeowners during 2007.  The challenge with interest rate adjustments is that the results of the changes are not easily measured until months or longer after the moves. 

In general, interest rate decreases are intended to spark a slumping economy by creating greater capital advantages and borrowing opportunities for businesses and individuals.  Increases are used to slow an overheating market that could potentially collapse.

The rate cuts over the last few months have been aimed at the financial services, housing, and mortgage sectors of the economy.  Cuts help businesses borrow more capital for business expansion, increase research and development, and expand job opportunities.  The increased job opportunities then create greater spending potential for Americans, which helps businesses, and so the cycle develops and carries forward.  Ultimately, businesses, banks, and consumers feed each other.  The growing economy and financial indicators fuel stock market enthusiasm. 

As with most financial investments, the stock market generally moves based on potential for significant developments.  Thus, the strong surge over the last couple weeks in the US markets has been lead largely by hopes for further rate cuts.  This put some pressure on investors when today’s (December 11) expected move of a quarter point drop was announced, rather than an optimistic half point.  The Dow dropped nearly 300 points following the slight decrease.

Some economists are concerned that Central Bank has acted to quickly and too aggressively to meet the needs of the housing market, lenders, and sub-prime mortgage borrowers.  The ideal flow of a market economy creates a near balance of supply and demand. 

Aggressive regulations or government maneuvers to help create this balance concerns some.  Many wonder if the attempts to boost the housing market and aid banks and borrowers could ultimately ignite too much of a fire with borrowers and lead to a dramatic turnaround and hyper growth, as opposed to more natural, stable improvements.

In addition to the indirect effect interest rate cuts provide for household consumers, there are also some immediate benefits.  Lowered interest rates, or prospects for lower rates generally lead to immediate drops in mortgage loan interest rates offered by conventional lenders.  These lenders pass on the savings given to them by the lower Fed rate in the competitive loan market.  Additionally, variable rate personal loans, equity loans and lines of credit, and credit cards, among others, often adjust when rates are cut.  All of these provide greater borrowing potential, lower payments and other household benefits.

Investors are looking for the interest rate cuts to spark the housing market and paint a better overall picture for the economy.  The Dow Jones had moved back within a few hundred points of its all-time high before today’s late drop, just a few weeks removed from being below 13,000.  Rate cuts and potential basing of the housing market, combined with the recent government intervention in the sub-prime loan market have renewed hopes for the economy.

Interest rate cuts have also helped lead to record lows of the dollar versus the major European currencies in recent months.  Foreign currency investors are trying to decide what to give more weight, the reduced interest available with the dollar, or the potential investment value for the dollar if the US economy picks up steam and the housing market reverses.

Stock Market Recap

US equity markets started off the trading week on a strong note with stocks overlooking negative news from Washington Mutual regarding office closing and layoffs, in hopes a rate cut Tuesday.  The Dow closed up a little over 100 points bringing the blue chip indicator within about 400 points of record highs.  Freddie Mac threw more worrying mortgage news to the market Tuesday by estimating $5.5-7.5 billion in home loan losses over the next few years and predicting increased loan defaults.  The hope for a strong loan cut and dovish Fed statement held the market slightly above break even in early afternoon trading.  The market dropped sharply in the mid-afternoon, following the expected ¼ point rate cut announcement, with the Dow closing down just short of 200 points.  Some investors had hoped for a bigger cut.  The Fed indicated potential for more cuts if the housing and mortgage markets did not show signs of improvement.

Neil Kokemuller
Tuesday, December 11th
5:01 EST

Neil Kokemuller is an Associate Professor of Marketing at Des Moines Area Community College in Des Moines, Iowa, USA.  He has a MBA from Iowa State University with a specialization in marketing.

Please note:  The information provided in this article is intended for informational and entertainment purposes, and not as advice for financial decisions or investments.  Actions taken on the basis of the information shared is at the sole risk and discretion of the individual.