After pumping perhaps unprecedented amounts of new liquidity into the nation's financial systems using unconventional methods, the Federal Reserve today returned to the old tried-and-true method of spurring economic hope by slashing the Federal Funds rate -- the overnight interest rate target for loans charged between banks -- by 75 basis points (0.75%).

The key short-term lending rate has already been moved down by 2.25% in 2008, and some observers believe that these rates will go lower -- perhaps much lower -- before the economy is fully back on track.

The Fed's overnight target rate for the cost of interbank lending of reserves is just that: a target. The actual cost of the money fluctuates both above and below that number as demands for those funds waxes and wanes.

For banks needing to borrow directly from the Fed, the Discount Rate was also sliced by three-quarters of a percentage point. "Discount Window" borrowing is said to carry a stigma, because a bank which approaches the Fed for funds is thought to do so only as a last resort, after all attempts to borrow money in open markets have been rebuffed. The public nature of borrowing from the Fed -- and the ensuing questions about asset strength or even solvency -- may keep banks from getting to the funds that they may desperately (or not so desperately) need to cover reserve requirements. The Fed's new Term Auction Facility (TAF) allows much of the same function of the Discount Window, but on an anonymous basis, and has been instrumental in restoring liquidity to lending markets. Notably, LIBOR rates have declined sharply, as the Fed's offerings of cash has served to temper demand for funds traded in US dollars on the London Exchange.

In characterizing its action today, the Fed said that "Recent information indicates that the outlook for economic activity has weakened further. Growth in consumer spending has slowed and labor markets have softened. Financial markets remain under considerable stress, and the tightening of credit conditions and the deepening of the housing contraction are likely to weigh on economic growth over the next few quarters." After a meager 0.6% increase in GDP during the fourth quarter of 2007, some believe that the first quarter of 2008 will show an actual decline in growth.

The Fed does believe that "Today’s policy action, combined with those taken earlier, including measures to foster market liquidity, should help to promote moderate growth over time and to mitigate the risks to economic activity. However, downside risks to growth remain."

There's good reason to be wary about the direction for both short- and long-term interest rates down the road, though. "Inflation has been elevated, and some indicators of inflation expectations have risen," noted the Fed, and higher inflation will tend to press long-term interest rates higher. Fighting inflation usually calls for higher short-term rates, so the minute the economy show signs of re-firing, it's a safe bet that short-term interest rates will rise, perhaps quickly.

That said, the Fed remains hopeful: "The Committee expects inflation to moderate in coming quarters, reflecting a projected leveling-out of energy and other commodity prices and an easing of pressures on resource utilization. Still, uncertainty about the inflation outlook has increased."

Mortgage borrowers need to be conscious of the fact that fixed mortgage interest rates often rise after the Fed has trimmed short-term interest rates. Why? If one of the tonics for a weak economy is lower short-term interest rates, and the Fed obliges, a growing economy becomes that much more likely to occur. A growing economy -- especially at a time of firm or rising inflation pressure -- will tend to press long-term interest rates upward.

In addition to inflation concerns serving to keep longer interest rates firm, perhaps more important is that mortgages remain out of favor among investors. In order to attract investors to buy mortgages, higher yields -- reflected in higher rates -- are required, relative to other fixed-income investments. The ability to make new, better-quality loans at higher yields (or spreads over incoming costs of obtaining funds) are the ingredients for profitable lending, and restoring balance to troubled loan books. Together, these represent keys to lender's willingness to keep lending, instead of simply holding onto more cash in troubled times.

Click here for an up-to-date graph and table of the Federal Funds rate.

Lower overnight and short-term rates, coupled with the Fed's new Term Auction Facility (TAF), have served to press common ARM indexes back down. LIBOR especially has benefited from the Fed's anonymous auction of fresh cash to lend. Treasury values are holding at multi-year lows, and LIBOR rates have moved closer to their normal relationship with other interest rates.

For Jumbo (aka "non-conforming") borrowers, fixed rate mortgage interest rates remain rather high. Temporary changes to Conforming loan and FHA limits may allow some borrowers access to new mortgage funds at lower rates, but those programs are just getting underway. If nothing else, Jumbo borrowers could consider new ARMs as a quasi-temporary product if a fixed-rate is too pricey for their budget.

Holders of ARMs tied to the COSI, COFI, or other deposit-based indices continue to see firm rates as competition for deposits -- the traditional way banks obtained money to lend -- remains spirited. Today's Fed action should serve to ease those rates for borrowers somewhat, but at the expense of savers looking for high yields for their money. The MTA has finally begun to reflect lower interest rates for one-year Treasuries and is drifting downward, helping borrowers whose short-term (often PayOption) ARMs become somewhat more affordable.

Holders of short-term PayOption ARMs should know that the true ("fully-indexed") rate of interest on an MTA-based ARM may be near 6.5% or so, and rather less for a LIBOR-based ARM. Even if these index values do improve in the weeks and months ahead, borrowers making a "minimum payment" as though the interest rate is just 1% or 2% need to be aware that they are accruing negative amortization at a rapid pace. Those making interest-only payments may continue see their costs go up and up even as their loan balance remains steady. Some are likely refinancing to more fixed-rate products.

Click here for a graphic demonstration of the relationship between the Fed Funds and mortgages.

As the Prime Rate is heavily influenced by moves in the Federal Funds target rate, a lockstep decline is likely to occur. As a market interest rate, there have been periods when the Prime has moved well in advance (or well after) any Fed move, but the relationship between Fed Funds and Prime has strengthened considerably over time.

Contrary to popular belief, the Fed has no control over the Prime Rate or any other market-based interest rates, but the Fed's observations about market conditions and changes to monetary policy do influence the overall cost of money. The decline in the Prime will bring some relief to borrowers with Home Equity Lines of Credit (HELOCs), who watched their interest rates more than double during the Fed's 2004-2006 cycle of increases. Over that time, the Prime Rate jumped from 4% to 8.25%, mirroring the 425 basis point increase in the Fed Funds rate. The decline the Prime Rate may be especially helpful to those whose HELOCs are part of a "piggybacked" mortgage origination, as that doubling in interest rate on a line taken in lieu of a down payment has no doubt caused at least some borrowers a fiscal headache. See the latest averages for HELOCs here.

Good credit quality 'conforming' borrowers now shopping for variable-rate products tied to short-term indicators will generally find credit conditions to be improving at the moment. Lenders are aggressively seeking new business from solid borrowers with strong equity positions, so rates and fees may actually be improving for certain equity seekers. Despite today's change to short-term rates, existing holders of HELOCS and credit cards won't see any change for as long as three billing cycles. Borrowers with non-conforming credit needs will probably continue to find a challenging credit environment, and should be prepared to shop aggressively to find a suitable loan.

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Want to see today's ARM indexes? Click here.

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