Fed Rate Cut: How Will It Affect the Economy (And You)?

Today, the Federal Reserve is widely expected to cut the Fed Funds rate. Because the economy seems to be heading toward recession, the overriding goal is to stimulate the economy. And this means — as far as the Fed is concerned — making it cheaper for everyone to borrow money.

Because our economy runs on consumption fueled by debt, a Fed rate cut is expected to help stimulate the economy be stimulating more borrowing. Here’s one example of how it’s supposed to work for you and the economy:

1. The Fed cuts its rate, which influences consumer loans (including credit cards). This happens because the prime rate, in most cases, is the Fed Funds rate plus 3. So, the prime rate drops from 4.5% to 4% — assuming 50 basis point cut to 1%.
2. Your credit card interest rate drops. Credit card rates are prime plus whatever (I have one that is prime +7 and one that is prime +11), so theoretically, those drop as well.
3. With a lower interest rate, your monthly credit card payments drop. If you keep paying the same amount, more money goes to the principal, giving you more room on your credit card. If you just go with the minimum, you pay less money overall and have that money in your pocket. Either way, the hope is that this newfound “disposable” income finds its way into the economy when you buy stuff.
4. The economy is stimulated as people have more spending power and use it.

Also, the lower interest rates are meant to lure people into buying things with debt, since the rates are lower. Auto loan interest rates will drop, and that could make buying a car more desirable. Which would help a segment of the economy that is suffering rather badly.
Will the Fed rate cut work this way?

The big question now is whether or not today’s likely Fed rate cut will work this way. With credit card companies worried about increasing defaults, they are starting to tighten their requirements. Credit lines are being reduced (that’s right; check your statement — your $5,000 limit may only be $4,700), so even with lower rates, it may not mean more available for spending on the credit card.

Another issue is that credit cards may not see the benefits of today’s Fed rate cut.  Companies are raising their interest rates. Even if the Fed does cut rates, what if my card goes from prime +7 to prime +9? My credit card rate rises, and that means payments go up, leaving less discretionary income.

Fed funds rate and your savings account

Finally, for those who are trying to pay down debt and start saving money, this move really won’t help. While in most cases a Fed funds rate cut can help you with your debt issues, it never helps with your savings account. Your yield on cash (money market, high yield savings, CDs, etc.) is about to get lower. This means that yesterday was the time to lock in a relatively decent rate on a CD. Because the yield is about to go down.

image source: sxc.hu