Does the Fed's rate cut help consumers?

John W. Schoen Senior producer • Profile • E-mail

Last week's move by the Federal Reserve has some consumers asking - what's in this for me? Meanwhile, anyone who borrows money is looking ahead to the central bank's next meeting in December. Will they cut rates or won't they?

What or how does the reduction of 1/4 point mean to my buying or financing my house. Is this a break for banks and not consumers?
— C.C., Winter Park, FL

The Fed’s latest cut in the short-term rates it controls is certainly a break for banks. The rate cut lowers the cost of the banking industry's basic raw material: money.

The specific action applies to two separate rates which the Fed controls as the central player at the heart of the U.S. banking system. The first is called the federal funds rate — which is what banks charge each other for very short-term loans (think overnight.)

The reason banks shuffle money around for such a short period of time is that they are required to keep a minimum level of reserves at all times (even overnight) in case everyone shows up in the morning asking for their money back. But banks want to keep every penny working as hard as they can. So if they have a little extra at the end of the day, they lend it to another bank that came up a little short on reserves when the doors closed.

The way the Fed manages the rate on these bank-to-bank loans is by adding or draining money into the banking system by tapping its own holdings of Treasury debt and buying or selling them on the open market. That’s why the group that sets rates is officially called the Federal Open Market Committee; they decide what rate they want and then the Fed’s New York bond trading desk buys and sells what it needs to keep short-term rates at or near that target rate.

The other rate the Fed sets is the called the discount rate — which is the rate the Fed charges directly when a bank comes calling for a loan. (It’s not actually a discount any more, but we’ll leave the explanation for that for another day.) The so-called “discount window” is used when banks have trouble finding enough cheap enough money on the open market.

None of this matters to consumers until banks reset the prices they charge retail customers like us for loans and credit. Benchmark rates like the prime rate move up and down with changes by the Fed, much the way Wal-Mart passes along savings on T-shirts when it finds a cheaper supplier. But the Fed has no direct control over how much you pay for a credit card balance. That’s why it pays to shop around.

As for mortgages, the link is even less direct. You pay a different price (usually more) for a loan that runs for 30 years than you do for one that lasts 30 hours. That's because the price of money used to fund long-term loans like mortgages is set by the bond market, based mostly on news that effects the risk of the debt being repaid. That rate change shows up in the price agreed to every moment that two traders anywhere in the world complete a new transaction.

If the market decides that, say, a 30-year U.S. Treasury bond is a little cheaper than it was five minutes ago, that tends to bring mortgage rates down. (Though rates on new mortgages are usually set only once a day.)

So it’s entirely possible that a cut in short-term rates by the Fed could have little impact on the cost of a new or refinanced mortgage.

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