FOMC Cuts Fed Funds to 1%, Discount Rate to 1.25%, Mortgage Rates Even (Full Statement & Analysis)

The Federal Open Market Committee today cut the bank-to-bank Fed Funds Rate 50bps to 1% and the Fed-to-bank Discount Rate 50bps to 1.25%, citing a marked decline in consumer expenditures. These cuts to short term rate are aimed at getting short-term business-to-business lending back on track, which then feeds down to the consumer. Since most business loans range from overnight to one month, their rates take cues from Fed rates.

This Fed rate cut only has direct impact on one type of mortgage loan…Home Equity Line of Credit mortgages are tied to the Prime Rate which is tied to Fed Funds, so anyone with a HELOC will see -0.5% on their next statement. All other mortgages are tied to trading in mortgage backed bonds, and mortgage rates have increased after every Fed cut in the last year. Today is the only exception, where mortgage rates are even.

Today marks the 11th FOMC rate meeting—scheduled or unscheduled—since the credit crisis began. Since August 7, 2007, the Fed-to-bank Discount Rate has been cut all 11 times lowering it from 6.25% to 1.25%; and the bank-to-bank Fed Funds Rate was cut 9 of 11 times lowering it from 5.25% to 1%. Mortgage rates are even today, which makes today the first time mortgage rates have not increased after the last 9 Fed Funds Rate cuts. Every other time, mortgage rates increased following the Fed cut.

The reason mortgage rates don’t move with Fed rates is because they’re not tied to Fed rates; they’re tied to mortgage bonds. Mortgage bonds react in two ways after Fed cuts. First, bonds don’t like inflation because it eats away at their yields or rates of return. So when the Fed cuts short-term rates to stimulate economic activity bond markets perceive this to be inflationary and they sell off. When mortgage bond prices decrease in a selloff, yields or rates rise. Second, when the Fed cuts short-term rates, it usually means businesses don’t pay as much for their funds which means they can perform better, so investors often trade bonds for stocks. Again when bonds sell off in a stock rally, rates rise.

Looking forward, third quarter GDP (measuring economic growth) is released tomorrow and consumer expenditures (measuring consumer inflation) data will be released Friday. If economic growth is weak and inflation is moderating as estimates call for, mortgage rates will drop. The weakening economy can cause investors to seek the safety of mortgage bonds, which would help keep mortgage rates down, or at least in their current range, for the coming months.

FULL FED STATEMENT
The Federal Open Market Committee decided today to lower its target for the federal funds rate 50 basis points to 1 percent.

The pace of economic activity appears to have slowed markedly, owing importantly to a decline in consumer expenditures. Business equipment spending and industrial production have weakened in recent months, and slowing economic activity in many foreign economies is damping the prospects for U.S. exports. Moreover, the intensification of financial market turmoil is likely to exert additional restraint on spending, partly by further reducing the ability of households and businesses to obtain credit.

In light of the declines in the prices of energy and other commodities and the weaker prospects for economic activity, the Committee expects inflation to moderate in coming quarters to levels consistent with price stability.

Recent policy actions, including today’s rate reduction, coordinated interest rate cuts by central banks, extraordinary liquidity measures, and official steps to strengthen financial systems, should help over time to improve credit conditions and promote a return to moderate economic growth. Nevertheless, downside risks to growth remain. The Committee will monitor economic and financial developments carefully and will act 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; Elizabeth A. Duke; Richard W. Fisher; Donald L. Kohn; Randall S. Kroszner; Sandra Pianalto; Charles I. Plosser; Gary H. Stern; and Kevin M. Warsh.

In a related action, the Board of Governors unanimously approved a 50-basis-point decrease in the discount rate to 1-1/4 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, Cleveland, and San Francisco.