Impact of a Fed Rate Cut

What will happen if the Fed cuts the rate tomorrow? We've read about the overall effects. Lower short term rates may bring some stability to the bond market and lower long term rates will bring the cost of mortgage money down. It will further devalue our dollar making our exports cheaper around the world. By the same token, it will make imports more expensive and should encourage Americans to buy domestically produced products. It's generally hoped to stimulate the economy somewhat.

I want to look at the effects of a rate cut from the consumer's position. What is the impact of a cut in the Discount Rate to the average consumer? Most credit line mortgages as well as nearly all credit card interest rates are adjustable and are controlled by the Prime Rate. The Prime Rate moves in tandem with the Discount Rate. A rate cut by the Feds, as we had in September, has the immediate effect of reducing the minimum payments on nearly all credit line mortgages and credit cards. Since the average American carries a substantial amount debt, this increases the amount of disposable money available to most families at the end of the month. Americans have shown that given additional money, they are more likely to spend it than to save it, so this will encourage an increase in consumer spending. For the last few years our economy has been surviving on consumer spending and this helped keep the economy on track.

The downside of a rate cut is that it can fuel inflation. If you think back 20 to 25 years ago you will remember the problems we faced as a nation, because of inflation. We even went through a period of national price controls as a means to reduce the inflation rate. Double digit inflation was the norm and the goal was to force it into single digits. We've now gotten so accustom to a low inflation rate that the thought of inflation moving up to 4% is frightening.

Inflation erodes buying power but it does have a positive impact on people, companies or nations in debt. With the amount of outstanding debt in this country being so high, an argument can be made that inflation may actually be a good thing. I'm not suggesting that we develop a policy to encourage inflation, I'm just pointing out that if we begin to lose control of inflation there will be some positive effects in addition to all the negative ones.

There are no easy fixes to the financial problems we are facing. Until we all individually curb our spending habits and begin to take a long term view of our personal finances, we will always be in financial trouble. No government intervention will be able to get this economy back onto a strong foundation unless all Americans change their ways. There is no excuse for a negative saving rate for the citizens of the largest economy in the world.