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Fed Rates Rise, But Consumer Rates Stay PutThe Federal Reserve has raised key target interest rates three times since June. But you may not know it by looking at the interest rates consumers are paying. Consider how the Fed's actions have affected mortgages and bond yields. Home Loans The week before the Federal Reserve's June 30 meeting, when it raised the federal funds and discount interest-rate targets for the first time in four years, the average 30-year mortgage was 6.25%. Despite two more rate increases by the Fed in the summer, 30-year mortgages had fallen to 5.75% by mid September.1 This disparity highlights the fact that the way lenders view the threat of inflation is more important than the Federal Reserve's policies. Lenders want to be compensated in the form of higher interest rates if they believe that inflation will significantly erode the future value of money they lend today. The primary reason the Federal Reserve adjusts interest rates is to combat inflation by moderating economic growth through the availability of money. Why, then, has the Fed raised rates three times in the face of low inflation? Fed officials maintain that they are attempting to tune rates to a "neutral" level that neither stimulates nor restrains economic growth. After leaving interest rates at emergency lows for so long, the Fed apparently fears that being too accommodative with rates could spawn a future problem with inflation.2 Mortgage lenders apparently are anticipating that the Fed will be successful over the short term in combating inflation. Freddie Mac, one of the nation's largest sources of mortgage funds, indicated that it did not expect the Fed's latest rate increase to affect long-term mortgage rates significantly.3 Bond Yields As short-term rates rise, long-term rates have fallen, resulting in a flatter yield curve. A few weeks prior to the Fed's June interest rate increase, the yield on the 10-year Treasury bond, a bellwether for all long-term rates (including mortgages), was around 4.7%.4 On September 21, when the Fed raised rates for the third time, the yield on the 10-year bond fell to 4.04%. This amounts to an anomaly for the bond market, and it has puzzled bond traders, economists, and others who read the bond market for clues about the future. Falling bond yields, which are caused by rising prices, are typically a sign that lenders will have to offer lower interest rates in the future to encourage more borrowing. From this perspective, falling yields would seem to anticipate a slowdown in the demand for money, and by extension, economic growth. However, continued falling yields would indicate that consumers are willing to pay more to borrow money - hardly a sign of flagging demand. A flatter yield curve indicates that lenders are unafraid to lock up their money at current long-term rates because they don't see an opportunity to earn more by waiting for rates to rise. Buyers, too, are willing to lock in current rates because they don't expect rates to fall anytime soon. However, some bond-market observers say that long-term bond yields will head back up soon because they are down for other, temporary reasons, such as the recent spike in oil prices that has slowed economic growth.5, 6 Next Meeting There is some doubt whether the Federal Reserve will raise rates again at its November 10 meeting, and there is even more uncertainty about rate increases in 2005.7 This could help remove any incentive for buyers to wait on the sidelines for bonds to be issued at higher rates — more evidence for the possibility of continued low rates on long-term debt, such as mortgages. As you can see, the bond market can be complex and is influenced by a wide range of factors. Please call if you have questions, or if you would like to review your financial situation. 1, 3) Freddie Mac, 2004 |
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