Mortgage Woes: Action from the Fed

by Amy Lillard

This year has been a year of ups and downs for the housing market. In our continuing series, we chronicle news affecting the housing market and its major players.

First the Federal Reserve injected cash into the economy in a international concerted effort to increase market confidence and lending ability. Now the Fed has taken another dramatic step to prevent and respond to a growing credit crunch and market instability.

On Friday the Fed announced a half-percentage point cut in its discount rate on loans to banks. The announcement came with a carefully crafted statement as the Fed noted their actions were taken to prevent risk to U.S. business growth.

Federal Reserve Chairman Ben Bernanke said that incoming data suggests the economy is continuing to expand at a moderate pace, but "the Federal Open Market Committee judges that the downside risks to growth have increased appreciably"

"Financial market conditions have deteriorated and tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward," said Bernanke. The announcement also included the Fed's intention to continue monitoring the situation. They are "prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets."

What does this change mean? The interest rate the Fed charges to make direct loans to banks is now 5.75 percent, down from 6.25 percent. Unchanged, however, is the more important federal funds rate, which has stayed firm at 5.25 percent for more than a year.

The federal funds rate covers all loans that banks make to each other on a short-term basis. It affects credit cards, home equity lines of credit, car loans and other consumer loan rates. It's much more critical from a national economy standpoint: this rate helps determine interest rates such as bank's prime lending rates. Many industry folks believe if the financial market crisis worsens, the Fed will finally cut this rate.

The move by the Fed last week was alternately lauded and criticized. Many industry analysts say that the massive infusion of cash into the world's central banks earlier this month did not sufficiently calm investors. Instead, the markets are still in turmoil as investors are worried about what companies will next announce money problems, and what hedge funds will go under. This has led to an increasing tightness with credit by lenders and others (the "credit crunch").

This interest rate cut, though largely symbolic compared to a potential cut in the federal funds rate, will give another vote of confidence to markets and the economy, both desperately in need of the jolt. Criticism of the effort revolves around the desire for a federal funds rate cut. Industry professionals may get this wish after the central bank's next scheduled meeting of Sept. 18. The growing consensus is that the Fed will cut the federal funds rate by at least a quarter of a percentage point.