The Federal Reserve met today to consider policy
on short-term interest rates. The Federal Reserve had cut
two key short-term interest rates 13 times over the past few years to fight the recession.
But they have decided to raise rates during their
thirteen most recent meetings. Most believe the Fed will continue
raising rates next year as the economy continues to improve.
The two short-term interest rates the Fed controls are the federal funds
rate and the more symbolic discount rate.
The fed funds rate -- short for federal funds rate -- is the interest rate
at which banks lend to each other overnight. The Fed sets this rate by buying or
selling government securities until the target level is achieved.
As such, it is a market
interest rate.
The discount rate is the interest rate charged by a Federal Reserve
Bank on short-term loans to depository institutions. The discount
rate is important for two reasons: (1) it affects the cost of
reserves borrowed from the Federal Reserve and (2) changes in the
rate can be interpreted as an indicator of monetary policy.
These two rates do affect
the economy and it's performance. However, the rate cuts do take 4-6
months to work their way through the nation's economy.
Another rate influenced by, but not directly controlled by the Fed is
Prime rate. This is the rate charged
by commercial lenders on short-term loans to their lowest-risk, most
creditworthy customers, such as large corporations. Often serves as a
basis for rates on other loans.
Mortgages rates have been on
the decline for the last few years - reaching their lowest levels in
years.
The Fed's rate decisions affect mortgage rates setting the
levels of 1 year adjustable rate mortgages and indirectly
through the Fed's influence on longer-term rates that bond markets
set.
We've had many people call
us and ask - will mortgage rates go up when the Fed raises rates again?
The answer - it depends.
Basically, short term rates are raised on the basis to
slow economic growth and thus inflation. If the rate cuts are
successfully the economy begins to grow less rapidly, which decreases the
demand for capital. As the demand for capital lessens, over time, the law of supply
and demand ultimately pushes interest rates lower.
Mortgage
rates are often much longer-term financial instruments - not short term
rates - since mortgages
can be over a term as long as 30 years. But since most mortgages are
paid off when people move or refinance and do not last 30 years, mortgage rates tend to
closely follow the 10-year Bond yield. The 10-year Bond yield is
determined in the open market and do not always move in lockstep with
short-term rates. Fixed mortgage rates do not follow the variable short-term the fed funds or discount rate.
Shorter term ARMs usually do, but not the 15 and 30 year
mortgages.
Long-term
rates are sensitive to expectations about inflation. If short-term rates
like the ones the Fed controls are going up, this is usually an indication
that the economy is growing, and the increase in short term rates can
discourage borrowing
and spending, which can actually
cause inflation to decrease. Long-term rates, such as mortgage
rates, often fall when concerns about inflation decrease, but long term
rates rise when there are concerns about too much economic growth and
inflation.
The short term rates the Fed controls, and the long term bonds that affect mortgage
rates, have a basic opposing effect.
Basically, short term rates are increased on the basis to decrease
economic growth and prevent inflation.
Once rates are increased enough to decrease spending, economic growth decreases,
inflation risk decreases, and three
things happen to decrease long term bond rates, and thus mortgage rates.
1)
Businesses: Higher interest rates make it more difficult for
businesses to get loans to expand. Unemployment tends to rise, which eases
wage inflation, although at a human cost.
Demand for capital decreases, lowering
the interest rate through the laws of supply and demand.
2) Markets: Higher interest rates tend to attract investment into
bonds and other fixed-income investments, pushing down stock prices. Investors pull out of the stock market and push into the bond market to
seek safer yields.
This increases the price on the bond, thus lowering the rates. If
they see the Fed not acting aggressively enough, then they do the
opposite, raising rates
3) Consumers: Higher interest rates on credit cards and mortgages
can cool consumer spending, which accounts for about two-thirds of
economic activity. Since there is less risk of inflation in the future since economic
growth is not occurring as fast, the bond yield can be lower since it is
safer than the stock market, and there is no risk of inflation
overwhelming this return.
Since the bond and stock market and Real Estate make up the majority of wealth in our
country, when inflation rises to much, spending reduces, and once again
the cycle starts again.
Early the cycle of rate increases, it's hard to tell if the market will
view the fed as acting too slow, or too aggressively.
So it is a constant battle for the Fed between fighting inflation and
economic growth. The Fed tries to balance the equation so long term
rates and inflation is low, and the economy growing at a solid pace.
This is exactly what happened before the recent fed meeting about the fed
funds rate.
Mortgage rates actually rose because of inflation concerns. Housing
financial markets often are ahead of the Fed. Mortgage interest rates are determined
every day in active public markets. If those markets believe the economy
is growing too fast and causing inflation, and the market is concerned
that the Fed is not acting fast enough to raise rates and control
inflation, interest rates may increase as the markets anticipate
inflation.
It’s
almost impossible to accurately predict the future of something as complex
as the U.S. economy. However, it is important that mortgage consumers
understand some of the market dynamics. A lack of understanding can cost
them money.
As bond prices rise, the yield, or effective interest rate, drops.
If bond prices are going down (which means the yield or interest rate
is going up) that is generally a sign that higher mortgage rates are
ahead. A weak bond market will usually (but not always) cause mortgage
rates to rise. (see also
Bond
Prices and Bond yields)
Bond yields (rates) are usually high during
a strong economy where there is inflation risk, and lower when there is
little inflation risk.
The bond yield had been on the rise for the
last several months, as the bond market feels that the economy is in good
shape and growing at a steady and possibly inflationary pace. Mortgage
rates remained steady after the announcement on 11/1/2005, after rising
from 5.375%
to 5.875% over the last month or so. On the day of the 12/13/05
announcement, rates were up slightly.
Many
anticipate that long
term mortgage rates will fall if the Fed's action spark a decline in the stock market
by slowing the economy, which will cause money to flow out of stocks and
into bonds. This would cause bond yields to lower, which causes long
term mortgage rates to go down. Adjustable Rate Mortgage (ARM)
rates will go up.
There
is a bright side to this picture. The increase in short term rates is a
sign the economy is in good shape, and the increases now will keep
long-term rates lower over time by preventing inflation.
Consumers might want
to consider an interest only payment mortgage instead of a
30 year fixed - even some of these products have a 30 year fixed rate.
Or locking in a
lower mortgage rate for three or five years could make sense because most
people do not stay in a home more than five years, and those who do could
refinance later.
What's next? Depends on if the bond
market feels the economy is better than the fed thinks it is - or if the
fed is too slow to raise the short term rates again. If the economy
slows, bond rates will fall. For now, bond rates and mortgage rates
are moving higher, the question is how much and for how long?
Rates will rise for home equity lines if
the fed increases rates. Those are based on prime, and as banks
increase prime rate
from 7.00% to 7.25% - home equity lines and second mortgage rates will be
higher.
Also, rates for people with challenged credit will slowly fall, as the
economy is improving and this is lowering the risk early in an economic
growth cycle.
The overall result - rates are still very
low - it's a great time to refinance or buy a home!
Want more information on exactly how the
fed rates changes affect the economy?
Click here for
more details on effects of rate increases.
Click here for more
details on effects
of rate decreases.
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