Money and Financial Markets

Article excerpt

Many interest rates have fallen to their lowest levels in 30 years (except for a brief period in 1998 after the Asian financial crises and the Russian default). The benchmark effective federal funds rate averaged just 2.49% in October. After the Federal Open Market Committee's November 6 decision to cut the intended federal funds rate 50 basis points (bp) to 2%, the fed funds rate fell even further, averaging just 2.01% for the week ending November 21. Likewise, financing costs for both Individuals and corporations have dropped: The average 30-year conventional mortgage rate was 6.62% in October, and the Aaa-rated corporate bond yield dropped to 7.03%. In November, despite a rate cut, the 30-year mortgage rate and Aaa yield moved upward, averaging 6.75% and 7.16% for the week ending November 21.

None of this should be terribly surprising. During periods of economic weakness, the Fed characteristically pursues an aggressive policy of rate cutting to avoid retarding recovery. Although most private-sector yields are not tied directly to the fed funds rate, they tend to follow a similar pattern over longer periods. On November 26, the National Bureau of Economic Research's (NBER) Business Cycle Dating Committee announced that the longest economic expansion in U.S. history ended early this year, confirming many analysts' contention that the U.S. economy is experiencing a recession.

What may seem surprising is that the real costs of borrowing have not reached historical lows comparable to the nominal costs. Estimates of real interest rates subtract from nominal interest rates the portion that lenders may demand to cover inflation. The real effective fed funds rate, while lower than in recent years, has yet to dip below levels experienced in the early 1990s and is far from the lows of the mid-1970s and early 1980s. Real 30-year mortgage rates and Aaa yields have risen in the course of this year, behavior that is consistent with a belief that long-term prospects have improved and the economy may be headed for recovery. Ultimately, real rates should reflect the economy's long-term growth potential.

Other things being equal, low real interest rates and bond yields favor borrowers. However, commercial and industrial (C&I) loans and consumer loans have fallen sharply in 2001. C&I loan growth averaged 9. …