There has been much recent news coverage about the Federal Reserve, and the current interest rates. What does this all mean to the average homeowner?
- The Federal Reserve and the Federal Open Market Committee (FOMC) can only control two short term interest rates: The Discount Rate, and the Federal Funds rate.
- The discount rate is the least important rate of the two. The discount rate is the rate that the “Fed” charges other banks for overnight loans. It generally has only a small effect on the economy.
- The Federal Funds rate is the most important interest rate that the “Fed” controls. This is the interest rate that regular banks charge each other for overnight loans. This law gives the Federal Reserve power to trade in the bond market.
- It is through this power that the FOMC can direct the easing or tightening of money into the economy thus causing the Federal Funds rate to either be raised or lowered. For example, if they decide to sell into the bond market then more money is in circulation thus increasing the supply. If the supply of money is increased, then rates will go down because there is not as much demand.
- The opposite then applies if the Federal Reserves decides to buy securities from the bond market: they are reducing the amount of money out in the economy therefore creating more demand and ultimately raising interest rates.
- It makes sense that when money is in higher demand investors will pay a higher interest rate to use it. They do not directly lower or raise the actual rate.
- The FOMC is made up of the seven Federal Reserve governors plus five of the twelve Presidents of Federal Reserve district banks around the country. It is their votes that decide what will happen with the Fed Funds rate.
- The way the FOMC lowers the rate is by directing their trading desk in New York to buy U.S. Treasury bonds. This pumps money into the banking system and eventually into a larger economy.
- Lowering the Fed Funds rate is a normal strategy to averting or fighting a recession.
- On the other hand, the FOMC can tighten rates by selling treasury bonds, thus withdrawing money from the economy.
- The reason why the rate drops immediately when the Fed announces their intentions is because the bond traders immediately adjust the price of their bonds.
- This where we can understand the impact on the 30-year fixed mortgage rate. The fixed mortgage rates are tightly connected to the activity of the 10-year Treasury note. As the yield or rate on the note fluctuates so does fixed rates.
- We can never exactly predict what will happen with the fixed mortgage rates. For example, one time when the “Fed” lowered the Fed Funds rate, the feeling arose that economic data was hinting that a recovery was on the way. The stock market went up and the bond market got worse causing the mortgage rates to rise.
- The low rates we have today still are considered extremely low when you look at the history of interest rates!
Now is the time to refinance your mortgage or buy a property while rates are still this low!