Interest Rates

The Fed made a big cut in interest rates today. These days everybody looks to the Fed to fix all economic problems, but the funny thing is that they don’t really have very much control. Since the dot com collapse, the U.S. economy has been driven largely by the housing market. Homeowners were able to take out equity loans at low rates to get more money to spend. Since the housing market has collapsed, that is no longer possible for many people.

It follows that people are naturally cutting back on their spending. That means that stores are selling less, which means they are buying less, which means that manufacturers are buying less. The general effect is that more people get laid off, fewer people get hired, fewer people get raises and bonuses, and there is less money to spend. This leads to a slow downward spiral. Of course it won’t go down forever or even necessarily all that long. But it will go down for some time.

Now, if mortgage interest rates start to drop, then people will continue to be able to borrow money on their houses, and continue to be able to spend it (only qualified people, of course–no more subprime borrowers). Also business will find it easier to borrow money to invest. That is what the Fed is trying to do by cutting their rates: make it easier for people to borrow and spend and invest, to move the economy from a downward spiral into an upward spiral.

The funny thing is that the Fed has been lowering rates for a few months, but the rates for mortgages and other borrowing haven’t dropped. That’s because the subprime mortgage debacle has made the big lenders nervous about lending money. They are worried about maintaining reserves for the loans they have out, and they’re worried about whether they will be able to sell their debt to others as they have gotten used to doing.

Having the Fed drop their rates isn’t going to make the lenders any less nervous. It’s not that they don’t have the money; it’s that they are scared to lend it. There is a point at which they will happily borrow from the Fed and lend to others at lower rates then we have today; I don’t think we’ve reached that point yet.