Rate Cut Follows Bailout, But Will It Help?

The Fed cut the federal funds target rate by 50 basis points this morning on the heels of announcing that it would lend directly to companies. Meanwhile, Moody's says the bailout may not bolster banks' credit ratings.

The U.S. Federal Reserve lowered its target for the federal funds rate to 1.50 percent on Wednesday — a 50 basis points drop. The Fed’s Open Market Committee lowered the benchmark lending rate “in light of evidence pointing to a weakening of economic activity and a reduction in inflationary pressures,” it said in a statement. The federal funds rate is the interest rate that banks charge each other for overnight loans.

Meanwhile, the central banks of England, Switzerland, Canada, and Sweden also cut their target rates by a half-point, according to Reuters.

The Fed said that the turmoil in the financial markets and the subsequent “restraint on spending” is further reducing the ability of households and businesses to obtain credit. Historically, lowering the federal funds rate to stimulate the economy can also increase the inflation rate.

However, the Fed points out that despite a higher than normal inflation rate, the OMC believes that the decline in energy and other commodity prices, and the weaker prospects for the economic activity have reduced the upside risks to inflation. “Inflation expectations are diminishing and remain anchored to price stability,” noted the Fed in the press statement.

Meanwhile, the Federal Reserve Board unanimously approved a 50 basis point decrease in the discount rate to 1.75 percent. The discount rate is the interest rate charged to commercial banks and other financial institutions on loans they receive from the Federal Reserve Bank’s lending facility.

The rate cut comes on the heels of the Fed’s creation of a Commercial Paper Funding Facility to buy short-term commercial debt from companies struggling to find financing. The announcement to lend directly to companies came yesterday, and is meant to give corporations some much needed liquidity. Indeed, the nearly $100 billion market for such credit has largely dried up.

Both actions come less than a week after President Bush signed a $700 billion rescue package allowing the Treasury to buy toxic securities from financial institutions. Earlier this month, the U.S. Treasury department established a temporary guaranty program for its money-market fund industry, while the Federal Deposit Insurance Corp. increased its depositor’s insurance to $250,000, up from $100,000.

Despite government intervention to help banks gain their footing, the rescue plans have not resulted in automatic credit rating upgrades for the banks, and in some cases “has not precluded downgrades,” says a new report from Moody’s Investors Services.

Moody’s emphasized that it is not taking systematic downgrades across the banking sector, and in general finds the government actions “generally supportive” of existing ratings. However, the bailouts — both in the U.S. and in Europe — have not led to upgrades because “our ratings already anticipated some level of support” stemming from distressed circumstances, “and because many of these measures are likely to be temporary in nature,” according to Moody’s chief credit officer Richard Cantor.

Moody’s explains that the temporary support may prove “insufficient” to deal with the bank’s underlying problems. That is, in some cases, the circumstances that led to the government intervention may have revealed “fundamental weaknesses in the bank’s asset quality or business model.”

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