Fed Fund closes to zero and the UK government improves the guarantee scheme

Yesterday the Federal Reserve cut the main US interest rate to “a target range” of between zero and 0.25% and said it “will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability\".

It adds that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.

The Fed has already announced that over the next few quarters it will purchase large quantities of agency debt and mortgage-backed securities “to provide support to the mortgage and housing markets, and it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant”.

The statement added that the Fed is also evaluating the potential benefits of purchasing longer-term Treasury securities.

With the Fed Funds rate now virtually as low as it can go the Fed is already resorting to other measures to boost the US economy.

The rationale for buying large quantities of agency debt (in other words, Fannie Mae and Freddy Mac) is to push long term interest rates down as well as short term rates.

This is even more relevant in the US than the UK as most US mortgages are fixed for 15 or 30 years.

The tactic is already working, with rates on both 15 and 30 year fixed rate mortgages having fallen by 0.55% over the last month.

All this just reinforces the message we at John Charcol have been giving clients for some time.

Trackers, preferably with a droplock option but with no collar, remain the product of choice.

The longer interest rates stay low the more likely there will in due course be a once in a lifetime opportunity to buy a cheap longish term fixed rate.

In the UK the government has improved its Credit Guarantee Scheme by cutting the fees it charges for providing the guarantee and extending the maximum term of the guarantee from 3 years to 5, in the hope this will encourage the participating banks and building societies to both increase lending to consumers and reduce its cost.

It will also offer guarantees for borrowing in a wider range of currencies than just Sterling, Euros and US Dollars, as at present.

The statement from the government said: “Taking account of international experience, and market developments, the government is adjusting the formula that determines the fees paid by participating institutions for use of the Government guarantees.

“This will lead to those institutions paying a lower – but still commercial – fee for use of the Scheme, reducing the cost of funding under the scheme, and more closely aligning the scheme with those in other countries.”

Extending the term of the guarantee to 5 years should provide considerable extra comfort to the banks and reducing the onerous cost of providing the guarantees is long overdue.

The government’s comment that the new rates are still “commercial” is no doubt partly to appease the EU, but also an admission that the original fees were excessive.

The Prime Minister Gordon Brown may think he has saved the world but with our bank rate rapidly approaching zero he may yet need to copy the Fed by actually buying securities.

But this expansion of the guarantee scheme is very sensible and the sooner it is extended to the issue of new mortgage backed securities as was recommended by Sir James Crosby in his report last month, the sooner we will see whether just providing guarantees, as opposed to actually buying securities, will be adequate.

With a huge volume of wholesale funds due to mature next year, and little chance currently of many lenders being prepared to roll them over, implementing the Crosby Report is much too urgent for the Chancellor to sit on it until the Budget.