The Federal Reserve
by Tom Furio
What is the Federal Reserve, or "The Fed"? Most people would answer that those are the people that raise and lower interest rates. Some think that that also includes mortgage interest rates. That could not be further from the truth.
The Fed, is the central bank for the United States. It was established in 1913 with the passage of the Federal Reserve Act. It was created to provide national economic stability. It was soon faced with what became the Great Depression. Its inability to handle that event led to a broadening of its areas of responsibility.
Today, when we hear news from The Fed, it is usually in the context of either the condition of the economy or the Fed Funds Rate. Wall Street listens intently to The Fed's analysis of the economy. They parse every word and you can see fluctuations in the stock and bond markets based on their perception of The Fed's statements.
The other topic we hear about when we hear news from The Fed, is the Fed Funds Rate. This is the interest rate charged for funds that banks borrow from each other. This is not a rate that we are all that interested in for the most part, with one very important exception. The Prime Rate is always 3.0% more than the Fed Funds Rate. So, if the Fed Funds Rate is 5.25% that makes the Prime Rate 8.25%.
So if the Prime Rate is 8.25%, why are mortgage interest rates in the low 6% area? It's simple - first mortgage interest rates ARE NOT tied in any way to the Prime Rate. The Fed adjusts the Fed Funds Rate in an effort to manage the overall economy. If a bank needs more funds to replenish its reserves in the Federal Reserve System, it will borrow money from a member bank. This cost of money is then passed on to customers who borrow money from that bank. As that consumer interest rate adjusts, so does our willingness to borrow money.
Lower interest rates will stimulate economic activity by lowering the cost of borrowing money, making it easier for consumers and businesses to buy and or build their businesses. Raising interest rates slows the economy by increasing the cost of borrowing money to buy and or build businesses. While these rates are very influential in our overall economy it is important to remember that these are not first mortgage interest rates.
As of early 2007 The Fed has ended an extended period of rate increases. During this time, mortgage interest rates stayed the same and in some cases actually decreased! How can this happen?! It's really not all that complicated - let me explain.
Let's say you were a mortgage bond holder, you were the person who loaned the money to a home buyer. You will loan them $100,000 at 6.5%. Not only will you receive a portion of the $100,000 by the end of the year in principal payments, you will also receive $6,500 in interest from the money you loaned. That sounds pretty good right? Let's suppose that the economy was indicating that we are entering an inflationary period in the near future. Over time, the $6,500 would become less valuable every year that the loan was outstanding. The inflated price of goods will allow you to buy less with the same $6,500. In response to this future risk if the mortgage bond holders think we are entering an inflationary period, they will raise first mortgage interest rates.
When The Fed raises the Fed Funds Rate, it is seen by the mortgage bond holders as The Fed controlling inflation. This economic control boost the confidence of mortgage bond holders in future values of their money therefore putting them at ease. With this new level of confidence they are far less likely to require higher of interest rates. In some situations Mortgage Interest Rates can even go down as The Fed raises the Fed Funds Rate. This phenomenon is caused by the larger degree of inflation stability and therefore a longer term level of confidence in the bond market.
In summary - don't believe all that you hear and read in the media. When The Fed raises rates, mortgage interest rates may come down.
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