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The Federal Reserve Board Open Market Committee slashed interest rates Sept. 17 by another half point, the eighth cut this year. The latest move had become widely anticipated in the preceding days given the tragic events of Sept. 11.
While the long-term merits of the U.S. economy remain intact, the Fed is acting to minimize the short-term damage to an economy already teetering on the brink of recession.
The U.S. economy may have been halfway to a recession before last Tuesday's terrorist attack. The conventional definition of recession is two consecutive quarters of declining gross domestic product (GDP) -- meaning that the aggregate value of all goods and services produced in the U.S. has fallen into a lengthy swoon.
Economists routinely revise their figures as they refine their data, and the GDP for the second quarter of 2001 is likely to be revised into negative territory at month-end, putting us halfway to a recession.
The tragic happenings of last Tuesday could potentially worsen economic weakness in the third quarter. It is this possibility the Fed wants to cushion against.
What is the outlook for consumer rates? Much of what we have seen in 2001 will remain in place. The trend of declining yields on savings and fixed-income products will continue indefinitely. Shorter-term certificates of deposit, such as six-month and one-year terms, are the lowest in more than seven years. Longer maturities such as the two-year and five-year are at, or near, record lows. Record lows could be reached on CDs of all maturities by year-end. The safe haven investors have sought from stock market volatility may be a break-even prospect at best, after inflation and taxes are considered.
The falling rates seen on consumer loans such as automobiles, credit cards, home equity loans, and other secured and unsecured loans will continue, although to a lesser extent than what was seen in the first half of 2001. Interest rates are the lowest since 1994, and just one cut away from the lowest in nearly two generations.
The same "How low will they go?" question does not carry over to all consumer loan products. The presence of floors, a point beneath which rates will not drop regardless of how low interest rates go, is coming into play for home equity loans and credit cards. Variable-rate credit cards have been reaching the floor with increasing frequency, but lenders also use floors on home equity lines of credit. Even these rates will begin contacting the floor with each subsequent rate cut.
More-stringent credit requirements due to lender concerns about default and potential bankruptcies will also keep rates on many loans from falling in lock step with this and future Fed rate cuts.
One bit of good news exists for home buyers and homeowners mulling a refinance. The strength of the housing market in 2001 is partly attributable to the lowest mortgage rates since 1998.
While rates have had periods of being stuck in neutral, additional short-term economic weakness indicates that we have entered another period of rate volatility. How far they drop and how long they continue to fall will depend largely on the extent of the immediate economic setback.
The Fed is acting to minimize the setback, and will most certainly act again, possibly at its regularly scheduled meeting October 2. With low interest rates, low inflation, and additional government spending forthcoming, the long-term economic picture is bright. But the short-term economic outlook may involve a rougher road than anyone envisioned prior to last Tuesday.
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