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by Jennie S. Bev

The Federal Reserve is the economic institution in this country that can influence interest rates by issuing discount rates, also known as primary credit rates, that are intended to stabilize the financial system.

The decision to increase or cut such rates depends on multiple variables. In turn, the rates issued affect how these variables work in the free market, particularly in sensitive sectors of the economy, such as housing, auto and investment. Careful considerations in issuing a new rate must be made to ensure economic stability.

The latest discount rate, issued Oct. 31, is 4.5 percent, which is 25 basis points lower than the previous rate. Economic signs showed stability in the third quarter, while there were some strains in financial markets, the Federal Reserve noted. Economic expansion, however, was rather slow. At the moment, the most prevalent economic issue in the U.S. that may cause strong ripple effects in many areas is subprime loans, which became a liability ever since the housing market cooled recently.

The discount rate serves two functions: to facilitate monetary policy and to provide emergency liquidity to troubled banks. In the midst of a cooling housing market, which translates to an unprecedented number of foreclosures, many banks are experiencing liquidity problems. One of them is Citibank. Citigroup, the holding company of the bank, claimed to be writing down as much as $11 billion in bad subprime debt.

The current Federal Reserve stance on the interest rate, as cited from Inman News from Kroszner, “should help the economy get through the rough patch during the next year, with growth then likely to return to its longer-run sustainable rate. As conditions in mortgage markets gradually normalize, home sales should pick up, and home builders are likely to make progress in reducing their inventory overhang.”

Economists said that should the subprime loan trouble not improve, it might cause automobile and card credits to suffer as well.

The other influential variable in setting the discount rate is the inflation rate. Economists argued that, should the economy maintain its course with an inflation rate of slightly higher than 2 percent and a consumer rate of 3.5 percent, it is very unlikely the Federal Reserve would cut the discount rate again in December. However, the inflation rate should be read with caution, as it does not include food and energy price hikes or the drop in the value of the U.S. dollar.

There is a slight possibility that the Federal Reserve will reduce the discount rate again in December, assuming the housing market has not shown any improvements. However, with a stable inflation rate, a drastic cut is unlikely. With both variables considered, there is a strong possibility for the discount rate to remain as is.[]

Tracy Press, December 4, 2007

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