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   ARTICLE   |   From Scotsman Guide Residential Edition   |   August 2018

Get to Know How the Fed Affects Rates

Mortgage professionals should understand what the central bank’s policies can and can’t accomplish

r_2018-08_Lepre_spotMany people believe that the actions of the Federal Reserve have substantial impact on mortgage interest rates. This is not the case.

The Federal Reserve is the central bank of the United States. It acts as a reserve bank and requires member banks to keep about 10 percent of their customers’ checking and savings deposits at the Fed.

At best, the Fed’s impact on mortgage rates is indirect, inconsistent and relatively small. And that can be seen by the Fed’s policies and its effect on rates and the economy since the Great Recession. Mortgage originators, whose livelihoods depend a great deal on interest rates, should have a basic understanding of the Fed and its powers.

Largest piggy bank

The Fed is essentially the world’s largest piggy bank. It controls the money supply, affects short-term interest rates and helps regulate commercial banks.

The motivation for the creation of the Fed was to prevent bank panics. These are prone to occur when banks experience big losses, and depositors fear that their accounts are in danger — causing a significant number of people to withdraw the funds in their accounts.

Banks have an underlying problem that many people often don’t recognize. Their liabilities (depositors’ checking and savings accounts) are entirely liquid, while their assets are largely illiquid. If depositors show up at teller windows demanding their money, the bank cannot call you and demand that you pay off your mortgage loan, for example.

Banks need to meet specific reserve requirements at the end of each day. If a bank is cash short, either because people withdrew funds or because businesses with large credit lines tapped them considerably, that bank may need to borrow cash overnight so that it has sufficient reserves. This is almost always done by interbank lending (borrowing from another bank which has excess reserves) with the Fed acting as the lender of last resort.

In addition to providing stability to banking, the objective of the Fed is defined by Congress as framing monetary policy to maximize employment, stabilize prices and moderate long-term interest rates. The Fed runs the government’s monetary policy while Congress and the president run fiscal policy (taxes and spending.)

The Fed has significant objectives and powers, which it wields on a day-to-day basis. These powers relate to two things: controlling money supply and controlling short-term interest rates.

Magical money

The ability of the Fed to control money supply is, in a sense, magical. It can create money out of thin air. If the Fed wants to add to the money supply, it makes an announcement to the large investment banks that it wishes to purchase Treasury debt.

After the details are worked out, the Fed buys the Treasury debt from those banks by crediting their account at the Fed with money which did not previously exist. The Fed has the Treasury debt and the banks have newly created cash to lend.

This was what the various rounds of quantitative easing (QE) were about. A way to see QE in action was to pay attention to excess bank reserves. This is money banks own that is parked at the Fed and exceeds the necessary reserves. This money can be instantly deployed as a bank makes loans. The QE actions after the Great Recession increased excess reserves from $1.87 billion in August 2008 to $2.7 trillion in August 2014 — an astonishing 1,400 percent increase. 

If we are going to consistently add $1 trillion to the national debt every year, then monetary policy is an afterthought.

Unfortunately, just as that $2.7 trillion was being made available to lend, the Consumer Financial Protection Bureau (CFPB) created regulatory concern among banks, which had the effect of discouraging lending. This enormous increase in money supply coupled with years of a near-zero federal funds rate was intended to stimulate economic growth. While unemployment has dropped, what is still of concern is that gross domestic product (GDP) growth has been modest.

Average annual GDP growth has bumped around at an average of 2 percent since the Great Recession. In order to be able to generate enough tax revenue to get deficits under control, the U.S. arguably needs closer to 4 percent GDP growth.

Deflation disaster

The Federal Open Market Committee (FOMC) consists of the seven members of the Federal Reserve Board and five presidents of the Federal Reserve Bank including the one in New York. The FOMC dictates the target for the federal funds rate, which is the rate at which banks lend excess reserve balances to other banks on an overnight basis.

Whenever the Fed adjusts the federal funds rate, banks change their prime lending rate accordingly. The primary direct effect on mortgages from these adjustments is on some adjustable rate mortgages that are pegged to that prime rate. For the most part, the mortgage products impacted by changes in the prime rate are home equity lines of credit.

Changes in the federal funds rate and prime rate affect auto-loan rates and credit card rates far more directly than they affect mortgage rates.

More importantly, the FOMC reports and the speeches given by Fed governors make rather clear what Fed policy is regarding rates.

The Fed is in a rate-hiking mode. With the federal funds rate now at a historic low, there is little room to lower rates when the next recession happens. The Fed is raising the federal funds rate now to create space for it to be lowered again in the next economic downturn.

The words of the Fed and media coverage of Fed announcements tend to focus on the need to control inflation, but this misses what may be the Fed’s biggest fear: deflation. To understand this, look at mortgage debt. If you have a fixed-rate 30-year mortgage, your payment is fixed for the next 30 years.

In an inflationary environment, your mortgage payment will be less of an economic burden in the future, given the payment remains fixed, even as the relative value of the dollar decreases with inflation. Suppose we had deflation in the value of the money instead. That would have the opposite impact by putting downward pressure on prices and wages and thereby making the borrower’s mortgage payment more expensive in the future, relative to today.

This is precisely the situation that the nation’s biggest debtor — the Treasury Department — is in today. These poor folks are more than $21 trillion in the hole (our national debt), and deflation would make that $21 trillion in red ink even more painful as prices, wages and tax receipts decrease.

In November 2002, then Fed Gov. Ben Bernanke, who later became the Fed chairman, expressed this concern when he claimed that the major danger facing the U.S. economy was deflation. Deflation is the enemy of those in debt.

In the current economic cycle, the Fed’s message is as follows: “With unemployment this low, we are really concerned about inflation.” That outlook may fit with the traditional notion that once the unemployment rate falls below a certain level, wage inflation, and consequently price inflation, is inevitable. The fact is, however, that is not happening.

The April 2018 U.S. Bureau of Labor Statistics Employment Situation Report showed 3.9 percent unemployment and an average hourly wage increase of 4 cents. A decade ago, it was common economic wisdom that an unemployment below 6 percent would spark inflation. Wage inflation is more serious than inflation in goods prices because wage inflation is “sticky.” Wages do not decline to any significant extent when unemployment gets higher.

Unsustainable fiscal policy

Since mortgage rates tend to track with the 10-year Treasury yield, the ability of the Fed to affect mortgage rates comes down to how the actions and words of the Fed affect investors buying and selling of 10-year Treasury debt. Forecasting how markets will react in the short run to fundamentals, other news or word from the Fed has one inherent risk that gets little discussion. On any given day, that vast amount of Treasury debt is not traded.

The small portion of Treasury debt that is traded is not traded by big players who buy and hold, but more so by smaller players who intend to buy and sell fairly quickly. It is more difficult to forecast how these people will act or react. In the longer run, it is the investors who make the market.

Starting in June 2004, the Fed raised the federal funds rate 17 times in two years, going from 1 percent to 5 percent. In June 2004, the average 30-year mortgage rate per Freddie Mac was 6.29 percent. At the end of 2006, the average 30-year mortgage rate was 6.14 percent. The correlation at that time between the federal funds rate and mortgage rates was close to zero. Over the last 20 years, the federal funds rate and the average 30-year fixed rate mortgage have differed by as little as 0.50 percent and as much as 5.25 percent.

The ability of the Fed to affect mortgage rates through federal funds policy is very small. In fact, many overestimate the ability of the Fed to affect the economy in a major way. The underlying reason is that what has long-term effects on the economy is not monetary policy as set by the Fed, but rather unsustainable fiscal policy, which is managed by Congress and the White House. If we are going to consistently add $1 trillion to the national debt every year, then monetary policy is essentially an afterthought.

Longer-term interest rates are all about inflation or, more precisely, the perception of inflation. Price inflation is created either by increased demand or lower supply. The most striking thing about the U.S. economy is that despite many years of near-zero rates and the enormous increase in money supply, we still have seen only meager GDP growth. First-quarter 2018 GDP figures showed that consumer spending on goods actually fell. This is unlikely to translate into higher prices and inflation. 


 


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