Will Fed cuts save us from recession?

The U.S. economy and credit markets got a welcome -- and surprisingly strong -- jolt from the Federal Reserve on Tuesday, as the central bank sliced two key short-term interest rates by a half a point. That's more than most optimists had expected. Wall Street responded with the biggest rally in the Dow Jones industrial average in more than four years. The Fed now seems clearly on the side of bolstering the economy, putting fears of inflation on hold -- at least for the time being.

The central bank could take some of the scare out of Halloween with another round of interest rate cuts when it meets again Oct. 30-31.

HOUSING:

Mortgages and equity lines:

The cost of a home line of credit may fall more quickly than the rate on a long-term mortgage, but both likely are headed down. The cut to 4.75 percent in the federal funds rate, the price banks charge one another for overnight loans, will translate quickly into lower consumer and business rates. The drop to 5.25 percent in the discount rate, the price the Fed charges member banks for short-term loans, has a more indirect effect on market rates but its chief effect will be to make it easier for lenders to borrow from the Fed if they need cash. That in turn is expected to persuade banks to lower their lending rates, though the national average has already been trending down and is currently around 6 percent.

House prices:

Housing could continue to fall, but the Fed action is meant to put a floor under prices so that the pullback doesn't turn into a recession-causing rout. The big run up in home prices in recent years was driven by low mortgage rates, and by taking rates back down a notch the Fed is trying to provide a cushion for faltering borrowers and lenders. Lower interest rates on mortgages means more people will qualify for home loans or a refinancing. Nevertheless, the bottom may be months away in in areas where the housing bubble got most out of hand.

THE ECONOMY:

Lenders who don't want to lend and borrowers who don't want to borrow have slowed the growth of consumer and business spending, raising the odds of a recession. Financial market players have been waiting for the Fed to spring into action to reassure Americans that the troubles of the housing market can be managed and confined.

Growth:

Until the last month or two, many economists had expected the economy in the second half of the year to grow at a pace of 2.5 percent or higher, lower than the average 3 percent growth of the last 60 years. In recent weeks, forecasters have been ratcheting down their expectations, with even optimists expecting no more than 2 percent growth. Interest rate changes normally take months to work their way through the economy, so it could be spring before the Fed's moves are fully reflected in growth figures.

Recession risk: The chance of an economic tailspin were no more than a coin flip -- 50/50 -- earlier in the year, in the view of mainstream forecasters. Lately the odds have climbed to one in three, many believe. The Fed's cuts are meant to improve the odds.

INTEREST RATES

As outstanding loans started to look more risky in the face of rising home mortgage defaults, rates on loans -- particularly "jumbo" loans on expensive houses -- have jumped. The trend spread to other parts of the credit market, hitting everything from car loans to billion-dollar merger and acquisition deals.

The Fed's action is intended to counteract those fears and bring rates down for a variety of borrowers.

Consumer and business rates:

Credit cards, car loans and other consumer debt tied to short-term interest rates will get cheaper overnight. Leading banks responded to the Fed's action by cutting their prime rate from 8.25 percent to 7.75 percent Tuesday. The cost of borrowing also will fall for businesses with credit lines tied to floating interest rates.

Spending and saving:

Stores may find more people willing to spend once banks adjust payments on home equity loans, credit cards and other debt tied to short-term rates. Savers, who had to put up with several years of ultra-low rates on CDs and other savings products, will likely see banks again cut the interest they are willing to pay for deposits.

Mike Meyers • 612-673-1746

Mike Meyers • mmeyers @startribune.com