Fed's interest rate cuts don't come without risks

Monday, January 28, 2008

WASHINGTON -- Lowering interest rates -- the Federal Reserve's tool for bracing the wobbly economy -- is not without risk.

Fed chairman Ben Bernanke and his colleagues are expected to cut rates by as much as one-half of a percentage point at their regularly scheduled meeting this week. It would follow up a rare three-quarter-point reduction, ordered last week at an emergency session Bernanke convened after stocks worldwide plummeted, intensifying fears the U.S. was on the brink of a recession or had fallen into one.

To bolster the economy, the Fed probably will keep dropping rates for much of the year, economists predict.

That course, however, carries risks for the economy and people:

* The Fed can lower rates only so far -- in theory to zero. So the central bank must be careful it does not run out of room to cut rates.

* Lower rates could aggravate inflation. Consumers and businesses already are smarting from high energy prices. Dropping rates even more can further weaken the dollar. That could raise the cost of imported goods coming into the U.S. and lead American companies to raise their prices as foreign-made goods become more expensive.

* If rate cuts restored the economy to full throttle faster than anticipated, then the Fed could be forced to reverse course and abruptly raise rates. That would jolt Wall Street, businesses and people.

* Falling rates mean dwindling returns on savings accounts, certificates of deposits, money market mutual funds and other savings products. That is especially hard on older people, retirees and others on fixed incomes. They could face a double whammy if lower rates sparked inflation.

* Low rates, over time, could lead some people to live a lifestyle that they cannot afford. "You could see a restart to some of the behavior that was so prevalent just a couple of years ago, where borrowers were relying on home equity lines of credit and other inexpensive forms of credit to fund their discretionary spending," said Greg McBride, senior financial analyst at Bankrate.com.

* Short-term adjustable-rate mortgages could become much cheaper than longer term fixed-rate mortgages if the interest rate-cutting campaign continues. Home buyers could flock to the adjustable mortgages without seriously considering whether they could afford their mortgage payments if rates climbed. That is just what happened during the housing market's record-breaking days from 2001 through 2005. Today, record numbers of people have been forced from their homes -- clobbered by rising interest rates and weak home values once the boom went bust.

The Fed's key rate is the federal fund rate, which is the interest that banks pay each other on overnight loans. This rate affects many others that are charged to millions of consumers and businesses, and is the Fed's main tool for influencing national economic activity. It now is at 3.5 percent, but is expected to drop to 3 percent when the Fed wraps up a two-day meeting on Wednesday.

If that scenario plays out, commercial banks would be expected to lower their prime lending rate by a corresponding amount -- from 6.5 percent to 6 percent. The prime rate applies to certain credit cards, home equity lines of credit and other loans. Should all this happen, then both the funds rate and the prime rate would be at nearly three-year lows.

Some economists predict the funds rate will drop this year to 2 percent, a four-year low. Most believe Bernanke will not have to cut rates as deeply as did his predecessor, Alan Greenspan when Greenspan took on the 2001 recession.

By the summer of 2003, Greenspan had slashed the funds rate to 1 percent, a 45-year low. He held rates there for a year before the Fed began pushing them back up.

Critics contend those low rates helped to feed the housing frenzy, where home values zoomed and investors gobbled up risky loans, known as subprime mortgages, to borrowers with poor credit histories. When the housing market collapsed, the greatest damage was in subprime loans. Banks and other financial institutions have taken multibillion losses on these mortgage investments, which now have tanked.

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