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Fed Rate Cut May Give Consumers Some Breathing Room

Fed wants consumers to keep spending, to stave off recession

By Mark Huffman
ConsumerAffairs.com

January 22, 2008

This is a huge, drastic move – make no mistake about that," said MoneyWeek Deputy Editor John Stepek, writing on this Web site. "US interest rates have not been cut by this much in one go in more than 20 years."

But Stepek doesn't believe the Fed action is soon enough or substantial enough to head off a U.S. recession. He says it raises inflationary risks and will likely cause more damage to the dollar.

The rate cut – and anticipated further reduction at the Fed's scheduled meeting at the end of the month – is designed to lower borrowing costs and encourage banks to lend money. And it could turn out to be good news for some homeowners with subprime mortgages.

Economists have expressed concern about the number of subprime loans with very low "teaser" rates that are scheduled to reset to market rates in 2008. Last year's record wave of foreclosures, it was feared, could be equaled, or exceeded, this year.

When the mortgage reset occurs, a subprime borrower could go from a rate as low as 3.3 percent to a double-digit rate, resulting in an increase in their monthly mortgage payment of several hundred dollars. Many, on a tight budget to start with, would quickly go into default.

With interest rates falling, the threat has been lessened, if only slightly. When rates are reset, they will be established at a lower rate than they would have otherwise. While it's likely that many subprime borrowers will still be unable to make the higher payments, some undoubtedly will.

More importantly, others may qualify to refinance into a 30-year fixed rate mortgage at a very low rate, perhaps less than a point above their teaser rate. Locking in that low rate not only heads off catastrophe, but provides that affordable payment over the life of the loan.

The Fed action also encourages consumers to keep spending, since keeping money in the bank will provide even less in the way of interest.

The American Bankers Association Economic Advisory Committee last week said the economy may well face turbulence in the next few months, but should bounce back by summer.

"The drag from residential investment will continue to weigh the economy down, but we expect this to moderate after mid-year," said Peter Hooper, chair of the panel and chief economist, Deutsche Bank Securities, New York. "Fed rate cuts and a possible fiscal stimulus package should support stronger economic growth in the second half of 2008."

The consensus EAC opinion is that real economic growth will slow to roughly 1.25 percent in the first six months of the year, picking up to about 2.25 percent in the second half. The unemployment rate is expected to rise moderately to 5.3 percent through yearend and consumer prices are expected to rise 2.5 percent this year, down from 4 percent in 2007.

But the bankers do concede that the outlook for the economy has become more clouded in recent weeks. The group says the risk of substantially weaker economic performance is significant and the EAC now places the probability of recession close to 50 percent.

"Falling home prices, elevated energy prices, and strains in financial markets will continue to pose significant challenges to the economy," Hooper said.

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