By John W. Schoen Senior producer
updated 11/5/2007 11:05:52 AM ET 2007-11-05T16:05:52

Last week's move by the Federal Reserve has some consumers asking - what's in this for me? Meanwhile, anyone who borrows money is looking ahead to the central bank's next meeting in December. Will they cut rates or won't they?

What or how does the reduction of 1/4 point mean to my buying or financing my house. Is this a break for banks and not consumers?
— C.C., Winter Park, FL

The Fed’s latest cut in the short-term rates it controls is certainly a break for banks. The rate cut lowers the cost of the banking industry's basic raw material: money.

The specific action applies to two separate rates which the Fed controls as the central player at the heart of the U.S. banking system. The first is called the federal funds rate — which is what banks charge each other for very short-term loans (think overnight.)

The reason banks shuffle money around for such a short period of time is that they are required to keep a minimum level of reserves at all times (even overnight) in case everyone shows up in the morning asking for their money back. But banks want to keep every penny working as hard as they can. So if they have a little extra at the end of the day, they lend it to another bank that came up a little short on reserves when the doors closed.

The way the Fed manages the rate on these bank-to-bank loans is by adding or draining money into the banking system by tapping its own holdings of Treasury debt and buying or selling them on the open market. That’s why the group that sets rates is officially called the Federal Open Market Committee; they decide what rate they want and then the Fed’s New York bond trading desk buys and sells what it needs to keep short-term rates at or near that target rate.

The other rate the Fed sets is the called the discount rate — which is the rate the Fed charges directly when a bank comes calling for a loan. (It’s not actually a discount any more, but we’ll leave the explanation for that for another day.) The so-called “discount window” is used when banks have trouble finding enough cheap enough money on the open market.

None of this matters to consumers until banks reset the prices they charge retail customers like us for loans and credit. Benchmark rates like the prime rate move up and down with changes by the Fed, much the way Wal-Mart passes along savings on T-shirts when it finds a cheaper supplier. But the Fed has no direct control over how much you pay for a credit card balance. That’s why it pays to shop around.

As for mortgages, the link is even less direct. You pay a different price (usually more) for a loan that runs for 30 years than you do for one that lasts 30 hours. That's because the price of money used to fund long-term loans like mortgages is set by the bond market, based mostly on news that effects the risk of the debt being repaid. That rate change shows up in the price agreed to every moment that two traders anywhere in the world complete a new transaction.

If the market decides that, say, a 30-year U.S. Treasury bond is a little cheaper than it was five minutes ago, that tends to bring mortgage rates down. (Though rates on new mortgages are usually set only once a day.)

So it’s entirely possible that a cut in short-term rates by the Fed could have little impact on the cost of a new or refinanced mortgage.

Is the Fed likely to cut interest rates again in December?
B.A., Indiana

We used to rely on the Answer Desk crystal ball to handle questions like this one, but every time we asked about the future direction of interest rates, it blew a circuit breaker. So we traded it in for a big screen TV.

Since then, we haven’t found anyone who can predict which way interest rates are headed — though there’s no shortage of people on business cable channels who are willing to try. About the best you can do is look at the same economic trends and financial forces that the folks at the Federal Reserve are watching, add a pinch of politics, and make your own forecast.

The Fed’s surprise half-point cut in September was designed to “shock and awe” the money markets to get them flowing again after a worldwide credit panic brought lending to a near standstill. Think of it as a gigantic, global financial defibrillator. (In this case, Chairman Bernanke forgot to shout: "Clear!")

The treatment seems to have worked, though the patient is still feeling a little woozy. So last week, the Fed cut short-term rates by another quarter point because of continued worries that the housing recession could spread to the wider economy. The markets had already placed bets that a rate cut was coming, in part because Wall Street is still worried about recent mortgage-related losses now being reported by banks and other lenders. Last week's 360-point air pocket in stock prices was due mainly to worries that banks may have to report more multi-billion losses down the road.

But the Fed accompanied the latest rate cut with a clear statement — or about as clear as the Fed ever gets – that, based on current conditions, it’s not inclined to cut rates further. Like a flustered parent at the supermarket checkout with a pack of kids Jonesing for a candy fix, Chairman Bernanke et al essentially said, “OK, OK. Just one! But this is the last time!” 

Further rate cuts are going be harder to justify unless the Fed gets clear signals that the economy is slipping into recession, and the latest data just don’t show that happening ... yet. Last week’s first peek at third quarter gross domestic product showed the economy humming along at nearly 4 percent, a reading that was echoed in Friday's stronger-than-expected report on new jobs created in October.

The Fed also has to keep a close watch on a potentially bigger threat: a return of inflation. As central bankers learned the hard way in the 1970s, once inflation gets started it can be very difficult — and painful — to stop. The latest inflation gauges used by the Fed show that prices are still fairly stable. But with oil approaching $100 a barrel, at some point those higher energy costs will start showing up in the cost of everything from gasoline to plastic packaging to shipping. Companies can — and do — absorb those costs for awhile. But when profits get squeezed too hard, they have no choice but to pass those costs along to consumers — or close up shop. That means inflation, or recession, or both.

The other number to keep an eye on — because the Fed is too — is the value of the dollar. A weaker dollar has already pushed up the price of gold and other commodities (in dollar terms). That’s bad news on the inflation front. Food prices are also rising — not a big deal in the short term, but worrisome if those price increases persist.

In the end, no one really knows what the Fed is going to do next, including the members sitting around that big table behind closed doors. A lot depends on what happens — especially as reported in the economic data — between now and the next time they sit down in December.   

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