Fed Cut Won't Help Lending Much

Another rate cut by the Federal Reserve might encourage banks to start lending again, but it sure doesn't offer much consolation to consumers.

The Fed slashed its overnight lending rate 50 points, to 1%, as expected on Wednesday, its lowest level since June 2003. Back then, the dramatically low federal funds rate was enough to spur a wave of borrowing by companies and individuals, so much so that a series of 17 rate increases followed from June 2004 to June 2006 as the Fed tried to temper inflation in a boom period.

Times are different, however. In 2003, the U.S. economy was coming out of a slump. In 2008, it is deteriorating.

Consumers are reeling from rising unemployment, falling housing prices and growing anxiety. Rate cuts ding already low rates on savings accounts, and the broad stock market index is down 36% so far this year.

Banks will start lowering their prime lending rates because of the Fed move, but they are not lending with the same gusto they were just two years ago. Even borrowers with stellar credit and cash collateral are experiencing a more rigid lending process.

The Fed's statement Wednesday cast a gloomy outlook that suggested another rate cut could come in December. Trading in the futures markets shows expectations of another 25- to 50-point cut then to levels not seen in 50 years. The Fed also lowered its emergency discount window lending rate to 1.25%, from 1.75%, on Wednesday. The rate cut was unanimous.

"The pace of economic activity appears to have slowed markedly, owing importantly to a decline in consumer expenditures," the Fed said Wednesday. "The intensification of financial market turmoil is likely to exert additional restraint on spending, partly by further reducing the ability of households and businesses to obtain credit."

The Fed runs the risk, though, of pushing rates to zero and then having more limited options to combat a prolonged slump. At a zero short-term interest rate, the central bank would have to work on adjusting longer-term rates. Meanwhile, it risks limiting its ability to battle the deflationary spiral of persistently scarce credit, declining profits and higher unemployment.

Regulators and the Bush Administration have been trying to shake the financial system loose by pumping trillions of dollars into it, notably a $700 billion plan to buy stakes in banks and buy troubled assets. The cut Wednesday comes less than one month after another half-point cut, that time coordinated with central banks around the globe.

In addition, regulators have unveiled all sorts of programs to backstop the short-term lending markets, money market funds, bank deposits and bank debt. On Wednesday, the Fed for the first time opened $120 billion worth of swap lines with four emerging-market central banks--in Brazil, Mexico, Korea and Singapore--calling them "systemically important economies."

The $125 billion earmarked for equity stakes in nine of the biggest U.S. banks is being spent this week. The Treasury and the Bush Administration have urged banks getting capital under this plan to go out and lend.

Bankers, however, have been taking a wait and see approach. Some are using the capital to buy weaker rivals.

Banks are reluctant to revive lending in any big way because of the bleak economic prospects. Spreads between the Fed's lending rates and the rate banks charge each other remained elevated.

The three-month London Interbank Offered Rate was 3.42% on Wednesday, a vast improvement from the 4.82% earlier this month but still high considering the corresponding Treasury bond yield. The effect of the Fed's actions on the interbank rate won't be known until it resets Thursday in London.

John Lonski, managing director at Moody's Investors Service, says the rate cut is a mild positive for banks and a "necessary step to enhance their profitability."

Economists noted the Fed's comments on inflation in Wednesday's announcement, which signaled that the central bank is less concerned that all of its efforts to rescue the financial system will result in inflation next year. "In light of the declines in the prices of energy and other commodities and the weaker prospects for economic activity, the committee expects inflation to moderate in coming quarters to levels consistent with price stability," the Fed said.

Some point out the dangers of this view. "The Fed is throwing gasoline on inflationary fire that it created but continues to ignore," says Peter Schiff, the president of Euro Pacific Capital. "Once highly leveraged players have been flushed out, commodity prices will resume their ascent, pushed skyward by the most inflationary monetary policy in history."

That's when consumers will feel the financial crisis the most.