The September 18 cut of a key interest rate should keep the trouble in the subprime lending market (September REMODELING, p. 31) from dragging the economy into recession, but experts caution that it is not the cure for the flagging housing market.

The Federal Reserve reduced the federal funds rate — which can be loosely defined as the interest rate at which banks lend one another money — by 50 basis points, from 5.25% to 4.75%. It was the first rate adjustment since June 29, 2006, and the first rate cut since June 25, 2003. It was also the first time since 2001 that the rate had been adjusted by more than one-quarter of a point in either direction.

However, the problem that this cut was designed to cure “doesn't have a lot to do with correcting home building moving forward,” says Kermit Baker, director of the Remodeling Futures program at the Joint Center for Housing Studies at Harvard University. The existing stock of unsold homes that has been keeping the market down is unaffected by this adjustment.

National Association of Home Builders chief economist David Seiders agreed. In his bimonthly e-mail newsletter, he wrote that “rate cuts by the Fed cannot immediately stabilize mortgage and housing markets,” something that Federal Reserve chairman Ben Bernanke has indicated he agrees with.

MITIGATING LONG-TERM PROBLEMS However, Baker did find something positive to take away from the rate cut. The prime interest rate — used for home equity loans — is generally set at three points above the federal funds rate, so it, too, dropped a half-point in September. “Financing projects will be cheaper,” he says. “In and of itself, that's good news.”

On the other hand, the cut represents something of a drastic measure. “The Fed had said they wouldn't bail them out,” Baker says, referring to the problems in subprime lending. “When it appeared that it might have long-term effects on the economy, they decided to step in and correct the problem. The notion that this is more serious than we thought is bad news.”

The rate cut was not altogether unexpected. In a late August address focused on the housing market, Bernanke said that while it would not be appropriate for the Federal Reserve to rescue lenders and investors, “developments in financial markets can have broad economic effects felt by many outside the markets, and the Federal Reserve must take those effects into account when determining policy.”

He went on to say that the Federal Open Market Committee would “act as needed to limit the adverse effects on the broader economy that may arise from the disruptions in financial markets.” Less than three weeks later, it did exactly that.

What more it will do remains to be seen. Seiders wrote that he expects two more cuts (of a quarter-point each) in 2007, but debate about the effect this cut would have on the overall economy left Baker unsure of the next move. With no official indication from the Fed, he could say only that “what they do going forward is anybody's guess.”

Figure This

Job cuts in September that are related to the construction industry
Source: Challenger, Gray & Christmas

Percentage of Americans who would support local regulations that would require all new homes to be more energy efficient at an added immediate cost of $7,500

Percentage of Americans who said they would pay an extra $5 per month in property tax to support a program encouraging homeowners to make energy-efficient home improvements such as replacing old water heaters and installing insulation
Source: GfK Public Affairs and Media/Yale School of Forestry and Environmental Studies

4 in 10
Mortgages given to minority home buyers in 2006 that were considered “subprime”

Overall decrease in minority home buying in 2006

Increase in African-American home buyers in 2006; the only minority group that showed an uptick in this area
Source: 2007 Annual Minority Lending Report