The Broader Reason for the Recent Fed Rate Reduction

The Federal Open Market Committee, the monetary policy making arm of the Federal Reserve System (the Fed), cut the Fed Funds Rate by 25 basis points on September 18th. Why was a reduction in the interest rate at which banks and other depository institutions lend money to each other on an overnight basis important to us? According to the Fed, the rate reduction was initiated in an effort to sustain U.S. economic expansion due to growing concerns about slowing global economic growth and mounting foreign trade tensions.  

Although the rate cut was meant to decrease short term borrowing rates in an effort to sustain economic expansion and stimulate further growth, there was a broader reason for the rate reduction. The Fed had an immediate need to quiet growing economic tension intensified by the recent turmoil in the short-term funding (overnight repo) money markets. Cash available to banks, hedge funds and other investors for their short-term funding needs all but evaporated overnight and interest rates in the money markets shot up to as high as 10% for some overnight loans, at more than four times the Fed’s daily rate.

This sudden and drastic increase in overnight lending rates suggests that the Fed may have underestimated how much cash is currently needed to keep the financial system liquid and operating smoothly. This prompted the Fed to step in with a series of market cash injections, totaling $128 billion, making this the first major market intervention since the financial crisis of 2008, to keep credit flowing through the U.S. financial system. Effectively, the Fed temporarily lost control of its own interest rate and needed to take immediate measures to regain control by providing much-needed market liquidity.

This event, however, will likely have little impact on the personal finances of Americans. The Fed rate reduction does not necessarily offset all of the Fed rate increases since the financial crisis of 2008 and, as rates continue to drop lending rates to near record lows, lenders are less than eager to decrease their profits by passing the savings along to borrowers through lower interest rates.

With the 30-year mortgage rate near record lows, currently averaging 3.73% nationwide as of September 30, 2019, as compared to 4.63% at the same time last year, according to BankRate.com, it will likely take an additional Fed rate cut of at least 25 basis points to measurably decrease the 30-year mortgage rate. Home equity loans, Home Equity Lines of Credit, credit cards and personal loans should also not see any significant rate changes as a result of the current Fed rate reduction. Savings accounts and certificates of deposit will show lower rates as a result. 

The exact cause of the recent cash liquidity crisis is thought to have occurred because of a few simultaneous events which essentially created the perfect storm for a cash liquidity crisis. Prompted by the impact of the financial crisis of 2008, banks today have much stricter cash reserve requirements due to more stringent banking regulations enacted by the Dodd Frank Act in 2010. The Act mandated that banks keep a lot more cash on their balance sheets, which forces them to borrow more short-term cash to cover obligations, thus becoming more active in the short-term markets. At the same time, corporations had to withdraw funds from their money market accounts to pay for their quarterly tax bills on September 18th. On the same day, the banks and investors who bought the $78 billion of U.S. Treasury notes and bonds sold by the government the prior week had to settle their transactions, further exacerbating a cash shortage.

The good news is that this crisis seems to have been corrected for now. Hopefully, the recent liquidity crisis was a one-time blip on the radar screen and there will be no lasting economic impact.