Wednesday, January 23, 2008

Fed Interest Rate Cut Unlikely To Make Borrowing Easier

When people hear that the Fed cut interest rates by 0.75 percent, many think it is a wonderful thing, and that now they will be able to borrow the money they need. Unfortunately, it doesn’t quite work out that way, especially in today’s financial climate. The Fed funds rate is simply the rate at which banks lend money to each other at the Federal Reserve Bank, that’s it. It is true that the prime rate goes up and down along with the Fed funds rate, but the problem right now is not that interest rates to customers are high, but that many customers who want credit can’t get it. These Fed interest rate cuts are unlikely to change that.

Right now, banks are turning their backs on any kind of loan that smells at all risky. That means low down payment, low documentation, small business and start up loans, along with others considered “risky,” are still unlikely to get funded.

Loans that have little risk, such as conventional real estate loans, should continue to get funded with little to no problem. The main thing to watch for with those loans is that traditional 30-year mortgages could possibly start seeing rates go up. Even though the Fed is lowering rates, the rates on long term mortgages can still go up because they are tied to bonds. Since these are long term bonds, inflation rates are more important than short term Fed interest rates, and inflationary pressure will begin to rise when the Fed drops interest rates this quickly.

The Wall Street Journal recently published an article that covered some problems that small business owners were having getting loans: “A recent survey by the National Federation of Independent Business found that 7 [percent] of the small-business owners surveyed in December said they were having problems getting financing, up from 4 [percent] in November. ‘I'm sure that everybody is being a little more careful. Certainly the banks that were aggressive are being more careful now,’ says William Dunkelberg, the federation's chief economist.”

So, while the Fed lowered the funds rate by 0.75 percent and is likely to cut the rate again at the next scheduled meeting, investors shouldn’t get overly excited. The stock market will do better than it would have otherwise, and the economy might get a slight overall boost; lending, however, is unlikely to get any easier. Interest rates aren’t the problems in this case, so dropping the rates won’t solve the problems. Instead of investors getting excited about the rate cut, they might want to start getting concerned about inflation. Inflation is already higher than it has been in recent memory, and it might only get worse from here. The Fed is making it clear that they are more concerned about appeasing the market and limiting recession fears than controlling inflation.

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