Will The Fed's Latest Rate Cut Help The Economy?

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For the second time in three weeks, the Federal Reserve has cut a key interest rate by half a percentage point, to 1 percent — the lowest level in four years. But is the action going to help get credit flowing again?

The short answer is that the cuts to the federal funds target should help, but not as much as would be expected under normal circumstances, NPR's John Ydstie tells host Michele Norris. He says the level of interest rates hasn't been the issue; the credit freeze stems from banks' unwillingness to lend for fear of not being paid back.

"These rate cuts aren't likely to ease the fears of not being paid back, but they will help struggling businesses and consumers," Ydstie says.

"That's because the federal funds rate dictates the prime rate. So businesses with existing credit lines and consumers with mortgages or credit card rates tied to the prime rate, they'll get a half-a-point rate cut, too," he says. "That should encourage some borrowing and consumption, and contribute to some economic growth."

But, Ydstie notes, Wednesday's rate cut isn't going to end the credit crisis.

The U.S. and other countries have made many attempts to thaw the credit markets, and Ydstie says there has been some improvement. The London Interbank Offer Rate, or LIBOR, which is a benchmark interest rate for all kinds of lending, including lending between banks, has continued to decline from recent record levels.

This shows that banks are more comfortable lending to one another, Ydstie says. But there's much less evidence that banks are boosting lending to businesses and consumers — something that must happen to make the economy go.

On Tuesday, the Fed instituted a program that should loosen this stream of money even more than the latest rate cut, Ydstie notes. The program, announced earlier in the month, began buying commercial paper — basically making short-term loans to large businesses that, in turn, make use of the loans for daily operation or making payroll.

But unlike big business, small businesses can't get loans in the commercial paper market.

"[Small businesses] normally get loans through lines of credit with banks," Ydstie says. "The problem is that banks are tightening their lending standards, and there's concern they might start to pull some of these credit lines. Treasury's injection of capital into banks is supposed to help ease that problem."

There's some criticism that banks aren't using this capital to make loans. But Ydstie points out that the money is just beginning to flow to banks, so it's hard to tell what they are going to do with it.

Some people say the Fed should start guaranteeing bank loans to small businesses with very good credit. That would be a big and complicated step for the Fed, Ydstie says.

Could the federal funds rate hit 0 percent?

Ydstie calls this a possibility. "The Fed is going to use every piece of ammunition it has to try to cushion this downturn, so we'll see just how low they go," he says.



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