Interest Rates and the Fed’s Control

The current state of the U.S., and world economies, has brought the talk of interest rates (and potential Fed rate cuts) bank into mainstream media.  Because of this, how many times (per day) are you fielding calls from borrowers asking when mortgage rates will be going down?

The media portrays the Federal Reserve as the “all-powerful” decision maker for mortgage interest rates, that as soon as the Fed hints or suggests at a rate cut, mortgage interest rates start crashing through the floor.  Most borrowers believe that the short-term interest rates (controlled by the Fed) and long-term interest rates (such as those connected with mortgage loans) are the same or are in tandem.  Nothing could be further from the truth.

When the media discusses the possibility of potential rate cuts, it is common to start hearing from borrowers asking if interest rates for home mortgages went down and how low they are expected to go.  The problem is the Federal Reserve is only cutting the short-term interest rates.  The Federal government controls short-term interest rates, but do not control long-term interest rates.

What the Federal Reserve controls directly are the Federal Funds Rates.  This is what the media refers to when they say the Fed is either raising or lowering rates.  This is the rate that banks charge one another for overnight loans.  Some of the interest rates that are directly and immediately influenced, by a Fed rate change, are credit card rates, auto loan rates and other loans that have short-terms (less than 10 years duration).

The Federal government can and does “influence” long-term interest rates (such as those connected with mortgage loans), but DOES NOT have any direct control over them.  The reason is mortgages are long-term loans heavily influenced by long-term interest rates.  Especially the rate of 10-year U.S. Treasury Securities.

To understand how little control the Federal government has over the long-term rates, think back to last December when the Fed raised short-term interest rates a quarter point.  At that same time, the Treasury rate and mortgage rates FELL sharply.

The bottom line to all of this is quite simple.  The stock market loves short-term rate cuts, but the bond market hates them.  When short-term rates are cut, you are adding to the money supply.  That has the potential to become inflationary.  Long-term lenders have a fear of inflation, which can eat away at the value of their money.

The main beneficiaries of short-term rate cuts are banks that borrow large amounts of short-term money, much of it to fund high-interest credit card loans.

Long-term rates are also important.  Rising long-term rates undermine the effect of falling short-term rates.  A good example of how all this comes full circle – one major factor stimulating consumer spending on big-ticket items, such as cars, has been the money homeowners take out of their homes, by refinancing or taking out a second mortgage.  If the refinance market, or purchase market, are slowed by higher mortgage interest rates, consumer spending may be affected.

So you see, the Federal Reserve isn’t the most all-powerful entity the media tries to make us believe.  They cannot just cut short-term interest rates carefree.  They have to worry about the long-term bond market as well.  All of this while attempting to stimulate the economy, short-term.

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