Fed Cuts Discount & Fed Funds 75bps Each, Mortgages Higher

After today’s scheduled FOMC meeting, markets expected a Fed Funds Rate cut of 100 basis points, but the Fed only cut by 75 bps. The Fed Funds Rate, a bank-to-bank lending rate, now stands at 2.25%. The Prime Rate is Fed Funds + 3%, so Prime is now 5.25%. Home Equity Line of Credit 2nd mortgages are tied to the Prime rate, so these loans will go down by .75% on next month’s statements. Most credit cards are also tied to Prime. All other mortgages are tied to trading in mortgage-backed securities, and mortgage bond yields were actually up 88 bps after the Fed announcement. This means most consumer mortgage rates (except HELOCs) will rise by about 25-35 bps tomorrow.

The Fed also lowered their Fed-to-bank Discount Rate by 75 bps to 2.5%. This following the emergency 25 bps Discount Rate cut over the weekend, and increasing the Discount Window terms from 28 days to 6 months So the Discount Rate is actually 100 bps lower than last week. The Fed’s Discount Window is intended to make the Fed as lender of last resort in a time of crisis, and at 2.5% for up to 6 months, banks won’t get a better deal anywhere else. It’s just a matter of whether they have good enough collateral (AAA paper is required) to get the loans–or even use the Term Auction Facility for that matter.

No doubt the Fed is doing all it can in a time of crisis. The only dissenting votes were Dallas Fed head Richard Fisher and Philadelphia Fed head Charles Plosser. In recent months, these two have been making very strong public remarks against aggressive Fed cuts because of a fear of inflation. The full statement of the Fed decision below discusses the conundrum that the Fed is in. The housing market and credit crunch is likely to drag the economy down for “the next few quarters” yet inflation is still a threat … and Fed cuts can contribute to inflation over the long term. Mortgage rates tend to be a leading indicator on inflation concerns in that they are particularly sensitive to inflationary sentiment. The inflation warning in the Fed statement is one reason why mortgage bonds sold off today, sending yields up. The other reason is that the stock market rallied strongly with the Dow up 420 points. Investors sell bonds to fund stock purchases in a rally like that.

The Federal Open Market Committee decided today to lower its target for the federal funds rate 75 basis points to 2-1/4 percent.

Recent information indicates that the outlook for economic activity has weakened further. Growth in consumer spending has slowed and labor markets have softened. Financial markets remain under considerable stress, and the tightening of credit conditions and the deepening of the housing contraction are likely to weigh on economic growth over the next few quarters.

Inflation has been elevated, and some indicators of inflation expectations have risen. The Committee expects inflation to moderate in coming quarters, reflecting a projected leveling-out of energy and other commodity prices and an easing of pressures on resource utilization. Still, uncertainty about the inflation outlook has increased. It will be necessary to continue to monitor inflation developments carefully.

Today’s policy action, combined with those taken earlier, including measures to foster market liquidity, should help to promote moderate growth over time and to mitigate the risks to economic activity. However, downside risks to growth remain. The Committee will act in a timely manner as needed to promote sustainable economic growth and price stability.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Donald L. Kohn; Randall S. Kroszner; Frederic S. Mishkin; Sandra Pianalto; Gary H. Stern; and Kevin M. Warsh. Voting against were Richard W. Fisher and Charles I. Plosser, who preferred less aggressive action at this meeting.

In a related action, the Board of Governors unanimously approved a 75-basis-point decrease in the discount rate to 2-1/2 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of Boston, New York, and San Francisco.