Will Fed Rate Cut Help Stem a Recession?

The U.S. Federal Reserve's dramatic cut in a key interest rate has calmed market anxiety in the short term. New York Times economics writer David Leonhardt gauges the rate cut's potential impact on a looming recession.

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STEVE INSKEEP, host:

Next, we're going to look behind some of the statements we've heard on the news or said on the news over and over again in recent days.

We've pointed out that the Federal Reserve lowered interest rates three quarters of a percentage point in effort to flood the economy with money and stave off a recession, or - if we're already in one - a worse recession.

To figure out how that really works - or if it does - we've brought in David Leonhardt, who writes about economics for the New York Times.

Welcome to the program.

Mr. DAVID LEONHARDT (New York Times): It's good to be here.

INSKEEP: How does this work? The Fed funds rate is money loaned from one bank to another overnight. What does that have to do with the economy precisely?

Mr. LEONHARDT: Well, the way the Fed gets to influence the economy is that it can loan more or less money to banks. And by loaning more money to banks, it injects money into the financial system, and the price of loans is the interest rate. So when the Fed injects more money into the system, it essentially lowers interest rates, and it lowers the interest rate that banks charge each other. And once that comes down, the interest rate on all sorts of other things comes down, like the interest rate on car loans or credit cards.

INSKEEP: Why do banks make overnight loans to each other?

Mr. LEONHARDT: Well, the way the financial system works, there's money moving around all the time, so banks are constantly lending money, not only to consumers but also to each other in order to shore up positions or move money around to different investments. This will increase economic activity. Fed interest rate cuts take some number of months to wash through the economy, typically six to nine.

INSKEEP: So banks have a little easier time loaning money to each other. Is it that banks don't trust their other banks to pay the loans back or is it they don't actually have money to lend?

Mr. LEONHARDT: Well, it's something in between the two. Banks need to keep a ratio between the value of their assets and the amount of money they're lending out and because of this mortgage crisis and because of the fears surrounding it, the value of the assets they have on their books has fallen.

In some cases they don't even know how much it's fallen because some of these assets have stopped trading so they don't know how to value them. And as a result of that, they are less willing to lend money out because if they lend out too much relative to the value of their assets, they then become unsound.

The fundamental problem we're facing here is not some sort of short-term loss of confidence or short-term loss of liquidity as much as it is the fundamental problem of we need to work ourselves out of this huge housing bubble. And so while the Fed can mitigate the downturn somewhat, either keeping us out of recession or more likely making the recession that's coming less deep, it can't solve the fundamental problem. The Fed can't make the housing bubble go away.

INSKEEP: David Leonhardt of the New York Times. Good talking with you.

Mr. LEONHARDT: Thanks for having me.

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