Impact of bold Fed rate cut may be limited

But rate cuts generally take at least six months to work their way through the economy. And until lenders get a better handle on the risks of lending — at any price — the Fed’s moves may have only limited impact.

“Central banks only control the price of credit and generally do not control the availability of credit,” said Richard Bernstein, chief investment strategist at Merrill Lynch in a note to clients. “In simple terms, they cannot force financial institutions to either start or stop lending.”

Meanwhile, efforts to head off mortgage defaults have been going slowly. Some lenders have gone out of business or been bought up by larger competitors, slowing the process of identifying borrowers at risk and working out new terms. Others lenders are not staffed well enough to take on the wave of calls from customers, a factor that Fed Chairman Ben Bernanke noted in a speech this month. Some borrowers, fearing the worst, are not responding to calls and letters from lenders offering to negotiate new mortgage terms.

And even when the borrower and lender are willing to rewrite the loan, many of the mortgages at risk were chopped up and sold to investors around the world. Those investors are part of the negotiation, which further slows the process.

As a result, only a fraction of troubled loans facing sharp increases in monthly payments have been salvaged by working out more affordable terms. Of the more than 2 million loans at risk, an estimated 54,000 loans were modified and repayment plans were arranged with another 183,000 borrowers during the third quarter of 2007, according to the Mortgage Bankers Association. During the same period lenders began foreclosure actions on another 384,000 loans.

While the problem may have begun in the U.S. mortgage market, the global stock market sell-off over the past two days has demonstrated that the credit crunch is now a worldwide event. Merrill Lynch’s Bernstein argues that market-based interest rates — over which the U.S. Federal Reserve has little control — are flashing warnings of a “growing global credit pandemic” that is beginning to hit emerging markets and developing countries. The fear is that those countries have weaker financial systems that may not hold up as well as developed countries in a financial storm.

It remains to be seen what the Fed’s next move will be when it meets next week for its regularly scheduled rate-setting session. A lot will depend, of course, how financial markets react to Tuesday's steep rate cut. But even if the Fed continues cutting, and lower rates begin to have the desired effect, they won’t come soon enough to have much impact on current economic conditions.

“At the least in the near-term it shores up confidence,” said Michele Girard economist  at RBS Greenwich Capital. “In terms of the economic impact, none of that will be felt until the second half of this year.”

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