Federal Reserve cuts interest rate, IU professors explain effects

Following a Federal Reserve federal funds rate cut of half a percent, banks around the world followed suit in a global effort to help the struggling economy.

This global rate cut, along with the $700 billion bailout plan passed last Friday, are part of an effort to alleviate the current credit crisis and ease economic concerns. IU experts said they think the effects of this rate cut could be complicated and multi-faceted, but believe the Fed’s move could put banks in better position to lend money to individuals for car, student and housing loans, among others.

“What a cut in the federal funds rate does is make it cheaper for banks to borrow funds from one another,” said Catherine Bonser-Neal, associate professor of finance at the Kelley School of Business at IU-Purdue University Indianapolis. “They then have more funds to then lend out to individuals when they need to do so. It represents an increase in the money supply.”

The Federal Reserve, the European Central Bank, the Bank of England and central banks in Canada, Sweden, China and Switzerland all cut rates by half a percent Wednesday. The central bank of Japan endorsed the move but did not cut rates due to worries of inflation. In the United States, the Fed from 2 percent to 1.5 percent – a move that will have a wide array of effects,  IU experts say.

The international cuts will lower the rates banks need to pay other banks when they borrow, so banks will be more willing to borrow money for loans to other people. This will increase the money supply because banks will begin to lend money to businesses and consumers more freely. Experts think this could increase confidence in the economy.

The cuts arise because the current problem in the economy stems mainly from a credit crunch – banks are unwilling to lend money among themselves and to businesses or consumers because they have a large number of defaulted and/or unpaid loans, which increased their debt to dangerous levels. By decreasing the costs of lending money, the Fed gave the banks a chance to again begin to accept loans and spur on resurgence in the economy.

This cut could negatively affect inflation. Because more money is in the economy, the value of a dollar falls. But Bonser-Neal said this problem is of little concern in this situation.

“Right now,” she said, “I don’t think that there are inflationary pressures as a result of the Federal Reserve action. Inflationary pressures will arise when they’re increasing the supply over and above what is warranted by the demand, but, right now, there’s just a huge demand for funds because banks are not willing to lend to each other.”
The short-term effects on the economy, Bonser-Neal said, are two-fold.

“The federal funds rate is the rate that banks charge each other when they’re lending out their excess reserves,” she said. “This means banks can borrow from each other more cheaply and then can send their money out into the economy. The other short-term effect is that it’s a way to increase confidence in the Fed’s seriousness and ability to address this financial crisis.”

This is not to say these effects will occur. For example, on Wednesday, the Dow Jones industrial average dropped a total of about 200 points after the emergency rate cut. This shows confidence has not necessarily increased as a result of the rate slash, and people might see this cut as the Fed showing concern rather than the ability to address the problem, Bosner-Neal said.

In the long term, however, this cut will allow banks to regain confidence and become “buyers” in the lending market again. Because people mainly look at the equity, or stock, as a market indicator, the rapid change in stocks may cause the cut to take a longer period of time to resolve economic issues, said Allen Snively, a lecturer of finance for the IU Kelley School of Business. 

Experts stress financial recovery will not happen overnight and that both lenders and consumers should be patient and ride out the coming struggles.

“You can expect equity markets to improve before the overall economy – stocks are a ‘leading indicator’ – but the economy is going to take some time to improve,” he said.