Rate Cuts Offer Both Reward And Risk

Consumers buy more, companies borrow more to expand and lots of people get a good feeling about their futures. These are the potential benefits from lower interest rates.

But there’s a downside, too.

Retirees living on interest from their savings could see their incomes decline, forcing them into higher-risk investments. Lower rates could also lead to risky business speculation that might make the next downturn in the economy more painful.

As as result, economists urged caution Friday as the Federal Reserve Board decides whether to continue on the course of rate cutting that it set the day before.

The Fed decided Thursday to reduce its target for the federal funds rate - the rate that banks charge each other for overnight loans - by 0.25 percentage point to 5.75 percent.

The Fed - which raised rates all through last year to cool an overheated economy and, thus, prevent inflation - reversed course when it appeared inflation was no longer a threat and economic growth seemed to be petering out.

If history is a guide, the move was the first of several as the Fed attempts to steer the economy to a period of moderate, sustained growth.

The obvious early beneficiaries of lower rates are the industries that are most sensitive to borrowing costs - housing, autos and related businesses.

Even before the Fed’s move, interest rates in the marketplace were dropping. One result was a 19.9 percent rise in May new home sales.

Since lower rates mean lower mortgage and credit card bills for many consumers, the confidence spurred by Fed rate reductions can itself have a positive effect by encouraging more spending.

Corporations eager to buy new equipment or buy out their competitors find themselves able to do so because borrowing is cheaper. This leads to expectations of higher profits, which prompts investors to start buying stock.

Not surprisingly, the Dow Jones industrial average climbed to record highs Thursday and Friday, closing the week at 4,702.73.

In fact, economists were hard pressed Friday to cite examples of business sectors that are automatically harmed by lower interest rates.

Retirees, of course, get less on their savings accounts and this could hurt business in areas where they are concentrated, such as Florida and the Southwest.

The real danger comes if rates fall too quickly.

Statistics released in recent weeks have shown the economy is doing better now than early this year making it premature to cut rates appreciably. For example, non-farm jobs rose a surprising 215,000 in June - twice the amount expected.

A climate of lower rates in the midst of a not-so-weak economy could stoke inflationary fires if industries expand too rapidly, putting a strain on supplies of raw materials and prompting labor shortages.

Easy money could also bring out speculators who take risks that could cause big losses during the next downturn in the economy, said John Lonski, senior economist with Moody’s Investors Service Inc.