Interest rates may be rising, we have heard recently from mortgage lending companies and news reports. A recent ad blitz by a well-known mortgage company, in fact, clearly suggested that the Federal Reserve would be raising mortgage interest rates in the near future, and urged potential loan customers to lock in home loans before the anticipated Fed increase. It took a few weeks, but the language in the mortgage lending ad was finally corrected.
In fact, the Fed doesn’t control mortgage rates. It does control two key policy-making rates that markets watch, however: the discount rate and the federal funds rate. What the Fed does with these will influence the direction in which interest rates in many markets, including home loans, are heading. It is this close connection between the Fed’s monetary policy and market expectations that leads to confusion over who is in charge of mortgage lending rates.
As the Central Bank of the United States, the Fed’s role is to regulate banks and to create and implement monetary policy. The monetary policy function—increasing or decreasing the amount of money and credit available to banks, and therefore to loan markets—is the Fed’s primary means of affecting economy-wide activity. Through its three monetary policy tools, the discount rate, bank reserve requirements, and open market operations, the Federal Reserve tries to promote economic growth and prevent wide fluctuations (especially on the down side) in business activity.
The Federal Reserve does not control the interest rates that private loan companies offer to mortgage loan customers. The Fed does have the power, through decisions made by its Open Market Committee, to determine the federal funds rate. This is the rate of interest that banks charge when they lend funds to one another in the very short-term (usually overnight) market. Since mortgage rates are sensitive to market expectations about the future, changes in short term rates like fed funds will cause lenders to adjust their rates to reflect those expectations. In other words, it makes sense that they pretty much trend together.
In its policy making role, the twelve-member panel that is the Federal Open Market Committee (FOMC) looks to the Fed’s research, as well as to other economic data, for recent and long-trend trend information. The panel then decides whether they think the economy needs economic stimulus to promote growth, or economic restraint to curb possible inflation. Lowering the interest rate at which banks can borrow directly from the Fed (the discount rate), or lowering the fed funds rate both mean the Fed is concerned about lagging employment and growth. Recent increases in interest rates, along with comments from the Fed, indicate that they have been viewing inflation as the more pressing concern of late.
Changes in Fed-controlled interest rates also mean changes in the nation’s money supply. When the Federal Reserve lowers the fed funds rate, it signals markets that funds for borrowing are more available—less scarce—and therefore less costly than before.
How can the Fed reduce the scarcity of money available to the loan markets? Unique among other agencies in the economy, the Federal Reserve can literally create money, and get it into circulation through the banking system’s credit markets. (It can also shrink the money supply if it wishes). When the Fed purchases assets from banks, particularly when it purchases U.S. Treasury instruments that banks hold as safe investments, it simply ‘pays’ for the purchases with dollars it has just printed, or (easier) just added to the Treasury’s checking account with the stroke of a pen. This ‘new money’ becomes the basis for a multiple of new loans and deposits throughout the economy, and becomes—the Fed hopes—economic stimulus.
Because these effects dissipate, the Fed continues to add dollars in an effort to continue the growth. And because added dollars also create inflation, the Fed eventually reverses course, raises interest rates, and tries to avoid recession. The back and forth direction of monetary policy is inevitable when monetary authorities have discretion, another reason that markets so quickly take their cue from the Fed.
Does the Fed create real economic growth? We know more home loans are generated when mortgage rates are lower, but the effectiveness of the Fed in promoting home ownership (one of its charges, actually) is a controversial idea, both in and outside of policy circles.