Fed cuts interest rates, but lenders still wary

Despite a 3/4-point rate cut Tuesday, mortgages are costlier than a month ago.

The Federal Reserve wants you to borrow – but your local bank may not be as enthusiastic.

Thenation's central banker has now lowered short-term interest rates tothe point that borrowing, especially for banks, is now essentiallyfree. Yes, free. Adjusted for inflation, interest rates – especiallyafter the Fed lowered rates by three-quarters of a percent on Tuesday –are now negative, meaning that the amount of money borrowed today isworth less when paid back.

But if you are hunting for amortgage, the rate is higher than a month ago. The same is true for afive-year loan, which a small-business owner might take out.

The reason? Banks are demanding more profit from each loan.

"Thismay sound coldhearted, kind of Snidely Whiplash, but the banks areadding margin between riskless Treasuries and their riskier loans,"says Gregory Miller, chief economist at SunTrust Banks in Atlanta."They are not doing it to be mean; they are doing it to remain viable."For example, a month ago a 30-year fixed-rate mortgage average contractinterest rate was as low as 5.61 percent, according to the MortgageBankers Association. Today, the same loan is about 5.98 percent. Afive-year business loan is now about 0.10 percentage points higher thanit was a month ago.

Not only are rates rising, but bankloan standards have tightened, according to a recent Federal ReserveBoard survey. Or, as Mr. Miller puts it, "I don't know how topolitically say this but banks don't want to lend any money."

Butthat may change. On Wednesday, the Office of Federal Housing EnterpriseOversight relaxed the capital requirements on Fannie Mae and FreddieMac. According to some estimates this will provide up to $200 billionin additional mortgage money this year and help struggling homeownersrefinance their homes.

Some very short-term interestrates, especially credit-card rates, are starting to budge. Accordingto, interest rates on variable-rate credit cards – abouthalf of the credit cards in use – have dropped about 3 percentagepoints. On a $5,000 balance, this would save about $150 a year.

"Thecaveat is that the bank is under no obligation to drop the interestrate; they can not drop it and make more margin," says Bill Hardekopf,CEO of LowCards. "The rate reductions are probably not being carriedover as much as the consumer would like."

But someanalysts anticipate that once banks start to get their balance sheetsin order, they will begin to compete for small-business loans onceagain. "Once the credit crisis is resolved, the interest spreads [thedifference between the most credit-worthy borrowers and those withlower credit ratings] will narrow and small business will be able toborrow," says Doug Roberts of Channel Capital Research Institute inShrewsbury, N.J.

In the past, when the Fed cutsinterest rates, only a portion of the cut has carried over to theborrower. "Historically they fall 40 percent of the increment of thedrop in the Fed funds rate" – the rate banks lend each other theirexcess reserves, says Miller.

Aside from the effect onthe consumer and business, there are some other implications for theFed's policy. For example, economists anticipate pressure will remainon the dollar – falling for the last six years – because foreigninvestors can get better returns in Europe, Australia, and other placeswhere interest rates are higher.

"When interest ratesare down, people from other countries won't want to keep their moneyhere," says Ann Owen, an economist at Hamilton College and a formereconomist at the Federal Reserve. "So demand for the dollar is down."

TheFed, in its statement issued on Tuesday, said the main reason for thesharp rate cut is that the "outlook for economic activity has weakenedfurther." The central banker sees weaker consumer spending and softerlabor markets. Financial markets are under "considerable stress," notedthe Fed, and the housing contraction will continue to weigh on economicgrowth.

And the Fed indicated it might make a further cut, since "downside risks to growth remain."

TheFed's action takes the Fed funds rate down to 2.25 percent. This isdown from 5.25 percent last September when it started cutting rates.Economists estimate the latest rate reduction means interest rates,adjusted for inflation, are now 1-3/4 of a percent in the negative.

Thelast time the US experienced negative interest rates was in 2003 whenthen-Fed chairman Alan Greenspan lowered short-term rates to as low as1 percent from 6.5 percent in May of 2000. "Negative interest rates arean unusual position to be in but not unprecedented," says Ms. Owen.

Atthe same time, some economists worry about the prospects for inflation.Average prices were 4.4 percent more expensive at the end of Februarycompared with a year ago.

In its statement, the Fedadmits inflation has been elevated and some indications of inflationexpectations have risen. However, it added that it anticipatesinflation to moderate, "reflecting a projected leveling-out of energyand other commodity prices and an easing of pressures on resourcesutilization."

One sign that the Fed governors areconcerned about inflation is that the interest-rate cut was notunanimous. Two of them, Richard Fisher and Charles Plosser, voted forless aggressive action.

Some outside economists fret thatthese members of the Fed's Open Market Committee, which sets rates,might be correct. "My biggest concern is inflation," says EugenioAlemán, an economist at Wells Fargo Economics in Minneapolis.

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