What is
Happening with Interest Rates
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Forget about the secrecy,
the mystery, the intrigue...since last summer, the Fed has been letting it all hang out.
In fact, the Fed has told us exactly what they were going to do. Get to a neutral policy
on rates.
So what's a
neutral policy, you ask?
That is where the Fed Funds Rate equals the rate of
inflation, plus 1.5%. With inflation presently around 2.5%, the Fed Funds Rate (FFR)
should be around 4% for the Fed to get to neutral. Right now, the FFR is at 3%, a full 2%
above where it was in June of 2004. So the Fed will continue to raise rates at a
self-proclaimed "measured pace" until the FFR is around 4%. The term
"measured pace" tells us to look for these hikes in ¼% increments, and for them
to happen at the Fed meetings, not as surprise moves.
Then what's
the deal with home loan rates?
The Fed has hiked 8 times and tripled the FFR since June
of 2004, but home loan rates have dropped by 3/4% during the same period. This clearly
demonstrates that the Fed does not control long-term or home loan rates. The Fed controls
overnight or very short-term rates that banks charge each other for funds. And the banks
do use this FFR to determine their Prime Lending Rate, often used to base auto loans,
credit lines and Home Equity loans upon.
On the other hand, longer-term investors that hold fixed
return Bonds such as fixed rate home loans, are interested in how the value or buying
power of the fixed payment return will hold up over time. So if inflation is moving
higher, the Bonds fixed return erodes. Why? Simply because inflation means it will cost
more down the road to buy the very same things they could today for less. This will cause
the investor to require a higher rate on future transactions to compensate them for the
erosion in buying power caused by inflation. If inflation moves higher, so will long-term
rates.
And when the pace of inflation declines, long-term rates
tend to decline as well. This is because the buying power of the fixed payment stays
stronger longer. Now here's where it gets interesting...a Fed hike can slow inflation,
which can actually help reduce long-term rates. This is exactly what has happened since
June of '04.
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So why is
this being referred to as a "conundrum"...don't they know this stuff?
Sure, but because there is no historical precedent for
what is currently taking place with interest rates, many are left scratching their heads.
But the discussion above should clear things up. And as for the lack of historical
precedent, the answer is also clear. In the past, the Fed raised rates to react to
inflation, but this time the Fed is raising rates in anticipation of inflation.
But why?
With no real inflation problem, why the rush to juice rates higher?
Yet another simple and logical explanation...the Fed is
"reloading". The primary way the Fed can heat up or cool down the economy is
with changes to the Fed Funds Rate. When the US economy went into a decline in 2001, the
Fed cut the FFR 11 times in 11 months, from 6.5% to 1.75%, with 8 of the cuts by ½%. The
swift move by the Fed made the recession one of the shortest in history. They were able to
quickly repair the US economy because they had the ammunition to do it. If the US economy
were to stumble when the FFR is already very low, the Fed would have a far more difficult
time stimulating the economy, as there is nowhere to cut lower to.
The Fed is very smart. A 3.5 to 4% FFR gives the Fed some
firepower to jump-start the economy if it slows or if an unfortunate event were to take
place. This target rate is also a good level to keep inflation at bay if the economy were
to pick up steam. The Fed is trying to find a "Goldilocks-approved" level for
the FFR...and so far appear to be doing a good job.
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