Federal Reserve Accepts Signs of Economic Slowdown - Cuts Discount Rate

In a dramatic, yet anticipated move, the Federal Reserve Board cut its discount rate by half a percent. The discount rate is the cost of money for banks and lending institutions that borrow directly from the Fed. The new rate is 5.75%.

The discount rate is different from the overnight lending rate which impacts short term mortgage rates, auto loans, credit cards and savings account rates. The Fed left the overnight lending rate steady in its last meeting August 7th.

Since that meeting the Fed has had to inject billions of dollars into the money supply to keep the overnight lending rate at 5.25%. This has been a result of banks across the country hoarding cash and diminishing the money supply. In Europe the same thing has happened with the European Central Bank injecting hundreds of billions of euros into the system.

This current activity is a direct result of fears concerning the subprime mortgage market. Buyers of collateralized loans, bundled together for trade on Wall Street as mortgage backed securities, have deep fears many of the loans may go bad. As a result no one is buying these once hot instruments and lenders are having to keep loans on their books which has decreased the amount of cash they can lend.

Right now the markets are acting on fear and speculation, not hard facts. Until the exposure to subprime and Alt-A loans fully plays out, the markets will continue to be volatile. Today's action by the Fed shows its willingness to step in and do what it can to calm the markets. Wall Street's initial reaction was a three hundred point bump to stocks after yesterday's wild ride. Over the past month the Dow has lost about a thousand points after setting a new record at 14,000.

Today's lowering of the discount rate suggests the Fed may cut the overnight lending rate at its next meeting in September. In the accompanying statement to the discount rate cut, the Fed indicated economic growth had now become a concern and it could take further action should the markets continue to decline -

In another statement, the central bank indicated that "financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward."

The Fed added that "although recent data suggest that the economy has continued to expand at a moderate pace, the Federal Open Market Committee judges that the downside risks to growth have increased appreciably" and that the Fed was prepared to take more action if necessary.

Should the Fed begin to lower the overnight rate, this will be good news for borrowers, homeowners seeking a refinance and potential homeowners. Wall Street is also hoping for a rate cut to keep business flowing at its current pace.