Update On The Fed Rate Cut

Doug Marshall
Market Assessment
Published October 14, 2008

Last week the U.S. central bank, in a coordinated monetary policy move along with other major central banks worldwide, lowered the federal funds rate by 0.5% to 1.5%.

The purpose of this decision was to help calm the credit markets by taking another step towards stabilizing the global financial system.

The federal funds rate is the interest rate that banks charge each other for overnight loans. This decision will have an almost immediate impact on credit card rates, automobile loans, and business loans.

The rate cut is meant to give the economy a slight lift during a tough time, by reducing interest rates and making it less expensive for consumers and businesses to spend money.

But what effect will the rate cut have on commercial real estate loans? The day before the rate cut the 10 year treasury rate was trading around 3.50%. Today it is trading at 4.01%, an increase of 51 basis points.

Why would lowering the federal funds rate by 50 basis points increase the 10 year treasury rate by about the same amount?

The reason is that the 10 year treasury rate is not set by the Fed but rather by the market. And who owns most of our treasury bills? Foreign investors do.

The cut in the fed funds rates has left many foreign investors worried about the Fed’s ability to contain inflation, which has led them to begin pulling their investments out of US dollar- denominated assets.

So, as foreigners reduce their investment in US treasuries it reduces the demand for US treasuries. The law of supply and demand dictates that if the supply is staying essentially the same and demand is weakening then the price is going to come down, pushing up the yield rate.

So in effect the rate cut by the Fed is actually having the opposite effect that many hoped it would. It’s actually causing long term interest rates, which are more important to the economy and particularly the real estate industry, to rise.

Go figure!

Sources:
Matt Heaton, Active Rain Real Estate Network, Update on the FED rate cut
Reuters.com, October 8, 2008 Fed funds rate at 1.5 percent, matching target rate