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What the Fed's actions may mean for your money

THE ECONOMY

December 17, 2008|Tom Petruno

The Federal Reserve tried for a major shock-and-awe effect with its interest rate cut and other moves Tuesday aimed at rescuing the economy from a devastating downturn.

For savers and investors, the shock may be that paltry rates on bank savings certificates will fall further -- forcing many people to consider moving cash into riskier assets, such as stocks.

For homeowners, the awe element may be the ability to refinance a mortgage at a rate of less than 5%.

The Fed said it would allow its benchmark short-term rate to fall as low as zero, from 1%.

And with that rate now at rock bottom, policymakers emphasized other steps they could take to drive down mortgage rates and other long-term interest rates, mainly by buying bonds and other securities for the Fed's own portfolio.

Wall Street's reaction was jubilant: The stock market surged, with the Dow Jones industrial average rallying 359.61 points, or 4.2%, to 8,924.14.

The broader Standard & Poor's 500 index rose 5.1%.

Investors also rushed to lock in yields on long-term Treasury bonds and other fixed-income securities.

In poker terms, "The Fed went all in," said Paul McCulley, a managing director at bond-fund giant Pimco in Newport Beach. "It was exactly what they needed to do," he said, to strengthen their commitment to ending the credit crisis and to set the stage for a turnaround in the economy.

Here are some of the potential effects of the Fed's moves on three key constituencies:

Savers

In part, by cutting the target for its benchmark short-term interest rate to a range of zero to 0.25%, the Fed was acknowledging market reality: That rate -- what banks charge one another for overnight loans -- already had fallen under 0.5% in recent weeks, a reflection of other Fed moves to flood the banking system with cash.

Still, with a new zero floor for the Fed's rate, banks now have more leeway to reduce further what they pay on deposits. Even though many banks have been eager to hang on to deposits, yields on savings certificates have been in a steady decline since early October.

The national average yield on six-month certificates was 2.11% on Tuesday, down from 2.14% a week earlier and 2.33% on Oct. 7, according to Informa Research Services.

By reducing the cost of money, the Fed wants to fatten banks' profits and thereby encourage them to lend more.

Savers, however, "are stuck holding the bag, as usual," said Greg McBride, senior analyst at Bankrate.com. "Yields are going to come down."

Interest rates on the short-term corporate, bank and government IOUs that money market funds buy also could continue to slide, further depressing fund yields. The average seven-day annualized yield on taxable money funds fell under 1% last week, to 0.94%, according to IMoneyNet Inc.

To earn a yield of 4% or more, savers will have to consider locking their money up for an extended period, perhaps at least 18 months.

That's a good idea for at least some of your savings, McBride says, noting that the Fed warned Tuesday in its post-meeting statement that the economy was "likely to warrant exceptionally low levels [of interest rates] for some time."

The silver lining, he said, is that with inflation dropping rapidly, savers' "real" returns -- after inflation -- have improved sharply.

Investors

Although the Fed's efforts can't turn the economy around on a dime, they can make investors more hopeful about the future. And boosting psychology is a big part of the battle, analysts note.

"The Fed made it very clear it is committed, without limits, to avoiding a depression," said David Kotok, head of money manager Cumberland Advisors in Vineland, N.J.

"This is a tremendously bullish move for all 'risk' assets," including stocks and bonds, he said.

Fed policymakers on Tuesday noted that they had previously agreed to buy large amounts of mortgage-related securities for the central bank's portfolio. Their statement said they stood ready to expand those purchases and to "consider new ways . . . to further support credit markets and economic activity" -- including by purchasing long-term Treasury securities.

Translation: The Fed is ready to do whatever it takes to break the credit logjam. As it competes with other investors to buy bonds, the effect is to push up bond prices and pull down yields.

The yield on the 10-year T-note plunged to a generational low of 2.36% on Tuesday, from 2.53% on Monday.

Pimco's McCulley said he believed the Fed could expand its financing efforts to the corporate and municipal bond markets, where interest rates have remained high. Those yields edged lower Tuesday.

For the stock market, anything that persuades investors that the economy will bottom in 2009 could cement the idea that share prices have seen their worst levels. Stocks worldwide have been moving up, in fits and starts, since about Nov. 20. The S&P 500 is up 21.4% since then.

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