Ask someone about mortgage rates, and chances are they'll tell you that they are set by the Federal Reserve. They'll be wrong. The Fed directly controls two very short-term interest rates. When it comes to mortgage rates, the Fed merely influences them. And only if it plays ball, which begs the question of who's influencing whom.
The Fed determines the "federal funds rate," the interest that banks charge each other for overnight loans. Overnight loans, you say? Who knew? Here's how it goes: Bank A makes a big loan on Tuesday, and as a result its cash on hand falls below legal requirements. Meanwhile, Bank B hasn't make any loans lately and has a big slug of cash sitting there, flaccid as a ... oh, forget it. Anyway, Bank A goes to Bank B and negotiates a short-term loan. Bank B is happy to lend, because it makes money on the deal. No one defaults on these loans. Ever.
These transactions are common, and the average of the negotiated interest rates is the fed funds rate. The Federal Reserve doesn't actually set the fed fund rate, but it controls it through its "open market desk." If the Fed wants the fed funds rate to decline, it will approach a bank and buy government bonds that the bank holds. The Fed pays for the the bonds by creating money in the bank's account which the bank can then lend. If the Fed wants to raise the fed funds rate, it sells bonds to the bank and the bank's lending reserve is reduced.*
The effect of these actions is to add or subtract money from the economy. Generally speaking, the idea is to create enough new money to keep the economy growing at its long-term potential rate, which most economists will tell you is 3% after inflation. If the Fed expands the money supply by more than 3% a year it's inflationary, and prices will tend to rise. If it adds less than 3% a year it's deflationary, and prices will tend to fall.
The Fed also sets the "discount rate." That one is usually window dressing. It's what a bank pays the Fed for a direct loan. Generally speaking, the Fed only makes direct loans if a bank is in trouble. You don't see a lot of troubled banks in the U.S., and you certainly don't hear about them. But the discount rate is widely understood as a symbol of what the Fed's doing with rates, so it gets a lot of attention.
In real life it's a lot more complicated than that, but I've just given you the basic idea. Now, here's what people tend to overlook.
1. When the Federal Reserve creates money, it's actually creating credit. The bank balance created out of thin air is done so that money can be loaned out. The Fed cannot create the ability to repay loans. If banks can't find enough creditworthy customers, it doesn't matter how much money the Fed created. And if people don't repay their loans, all the new credit in the world won't help.
2. Long-term interest rates are set in the market. Banks don't hold too many mortgages these days. Instead, home loans are turned into bonds, and the trading of those bonds are what sets mortgage rates. Mortgage bond rates exist in relation to U.S. government bonds, which are typically inflation plus a couple of percentage points. The bottom line: Buyers of bonds look closely at Fed policy and judge whether it's inflationary. If the Fed creates too much money, it will put upward pressure on all interest rates. Thus, the Fed doesn't determine mortgage rates, but rather it influences them by how much money it creates. Oh, and in any contest between the Fed and the bond market over long-term interest rates, the bond market wins.
Why care about all of this? Because, once you realize the limits of the Federal Reserve's power, then you can start understand what it can and cannot do in the current economic crisis. If you think the Fed can wave a wand and cut mortgage rates, all I can say is: think again.
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* Besides buying Treasury securities, the Fed often creates money by using "repos," or repurchasing agreements. When the Fed creates a repo, it buys securities with an agreement to return them in a day or two.
What repos prevent banks from having to call in existing loans, forcing a shrinkage of business activity, or worse. In short, repos help prevent credit panics. But, as this excellent article explains, they're not immediately inflationary because money created by a repo is repaid quickly.
However, if the Fed keeps extending or replacing repos, they eventually do become inflationary. I think long-term rates rose after the Fed's "rate cut" in September 2007 because bond traders judges the Fed's behavior to be the first of many similar moves. What's temporary today -- a repo -- will eventually turn permanent. That's what the financial markets told us.
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3 comments:
Traded opinions with you last night on CR. Enjoyed the discussion. Came to see your site. Did you just start? Good info here. I have a couple of comments on this post: 1) "if the Fed creates too much money, it will put upward pressure on all interest rates" The Fed creates money by buying bonds, as you stated. When the Fed, through open market operations, injects a lot of liquidity (buys a lot of bonds) bond prices will rise (rates fall) due to the increased demand. The upward pressure on rates that you speak of only comes when the money injected by the Fed finds it's way into "aggregate demand" causing prices to rise, or the expectation of prices to rise. In the current situation it is entirely possible that the Fed attempts to stimulate the economy by injecting money (buying bonds) only to have the foreigners that own vast amounts of our bonds sell the bonds at the same time. Basically, the Fed would be buying bonds from foreigners and the injected liquidity would end up in the country that sold the bonds to the Fed, not here in our country. That would create no increase in aggregate demand here, therefore no inflation here, therefore not higher rates here. 2) "in any contest between the Fed and the bond market over long-term interest rates, the bond market wins." I think if the Fed is determined to manipulate long rates it has the power because it can simply print money and buy (or sell) unlimited amounts of Treasuries to set the price anywhere it wants. Ben Bernanke said as much in a speech in 2002. Link to entire speech here: http://www.federalreserve.gov/boarddocs/speeches/2002/20021121/default.htm 3) "If you think the Fed can wave a wand and cut mortgage rates, all I can say is: think again." I believe they can control mortgage rates if they feel they must. The "free market" usually works just fine and I think the Fed has rarely (if ever) directly set mortgage rates because they had no need. But they could if they felt they must. They certainly influence the mortgage rate indirectly by manipulating short term rates. Mark
Before I answer you, a procedural nitpick: It would really help if you'd use some paragraph breaks when commenting. It's physically difficult to read a big blob of type.
Also, I should tell you that I'll be out of town and away from the Internet from Sep. 12 through Sep. 20, so don't take my lack of responses between those dates as anything but a function of my absence.
Now, to the substance:
1. My essays are already too long as it is, hence my not delving into fine-point detail at the outset.
I believe the following, but at some point will do more research to test my belief:
2. When it conducts open market operations, the Fed trades Treasury bills and bonds. It can have a very short-term direct impact on prices (and thus yields) on a given day, but it quickly dissipates due to the size of the market.
3. Once the aforementioned immediate impact dissipates, the monetary policy implications of Fed actions are a lot more influential on rates.
4. If the Fed creates too much money, the bond market will realize it and start raising the inflation expectations component of interest rates. If the Fed were to try and (for a time succeed) in driving down Treasury rates through massive direct purchases with fiat money, bond rates would rise elsewhere.
5. In any case, it's worthwhile to be pragmatic. Even under Bernanke, in whom I lack confidence, the Fed isn't going to be the 20-ton gorilla at Treasury auctions, nor will it be refinancing everyone's mortgage.
One other thing: There's no need to point out that the Fed indirectly influences mortgage rates through its open market actions. I wrote that in my essay; we agree on that.
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