Impact of bold Fed rate cut may be limited

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

The Federal Reserve's bold three-quarter point cut in interest rates was designed to stem the slide in the stock market and ease widening fears that the U.S. economy is sliding into recession. While the move helped slow a global slide in stock prices Tuesday, the long-term economic impact of cutting interest rates may be limited.

Why? To paraphrase an old campaign slogan, it’s the housing market, stupid.

Though mortgage rates have been low for months, the housing market is still stuck in its worst recession in decades. Even as housing starts continue to fall, the inventory of unsold houses has risen. With prices falling in many parts of the country, buyers are waiting for a turnaround before they start house hunting again. As foreclosure rates have risen, so has the pace of unsold houses being dumped on the market. 

At some point, the housing market will hit bottom. But the timing of that turnaround remains extremely murky — in large part because it’s unclear how many more homeowners will lose their homes to foreclosure this year and next.

Over the next several years more than $1 trillion in adjustable mortgages, written during the height of the easy-money lending boom, is scheduled to reset to higher rates. Unlike conventional ARMs that move lower as market rates fall, many of these mortgages are set to ratchet up to monthly payments that many homeowners won’t be able to afford.

Lenders and investors have already written off roughly $100 billion in losses so far. But no one knows how much more debt will go bad — or who is holding the bad paper. So even after the Fed has flooded the system with money, lenders remain tightfisted for fear that the borrower won’t be able to pay back the loan

“Large money center banks have virtually frozen their balance sheets, reluctant to lend even to good credit,” Scott Anderson, a senior economist at Wells Fargo Economics, wrote in a note to clients Tuesday.

That’s also why the stock market plunge came as a surprise to many individual investors. Though most people think of stocks when they think of the financial markets, the multitrillion-dollar credit market has been ailing since August, when mortgage losses began to hit lenders and investors holding with bad paper. Since then, efforts by lenders and the White House to head off the coming wave of resets and defaults have had little impact.

This is not the first bold move by the Fed to put out the bad-debt fire sweeping through the credit markets. In August, instead of cutting rates, the central bank took the unusual step of offering to buy tens of billions of dollars in loans to take them off lenders’ hands. Though the credit markets calmed down a bit in the fall, reports of continued bank losses in December — including Citibank’s sale of a large stake to raise cash — put lenders and investors back on edge.

Now with the U.S. economy apparently headed for a recession the Fed is hoping to revive it by marking down the cost of money. The hope is that lower interest rates will help spark a new round of borrowing among bargain hunters who may have been waiting like post-holiday shoppers.

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