Fifth Rate Hike Of Year - A Big Fat Yawn
by Henry Savage
Well, folks, Chairman Alan Greenspan and his merry band of policy makers at the Federal Reserve nudged rates up for the fifth time this year. The federal funds rate, which is the rate that banks charge each other for overnight loans, was raised to 2.25 percent -- up from one percent last June, a 60-year low. Banks parroted the Fed's move by raising the prime lending rate to 5.25 percent. This will trickle down to the American consumer because credit card and home equity loan rates are likely to rise as well. It would be an exaggeration to say that the market reaction to the move was muted. All the stock exchanges responded positively with moderate gains after the announcement. The move was widely anticipated so there were no surprises. Markets hate surprises. I think it's fair to say that Alan Greenspan has learned from his previous mistakes. The Fed has been forthright and upfront in communicating its intent to continue to raise rates at a "measured" pace. At the same time, it uses language such as "accommodative" in its official statements. On the one hand, the Fed says it will continue to raise rates. On the other hand, it says it will remain accommodative. Markets are interpreting such language as being flexible. The Fed will raise rates slowly, but will move less aggressively if economic indicators suggest an economic slowdown. I think the market likes the Fed's flexible and open attitude. In fact, each quarter-point move this year was widely expected, so there has been no exaggerated reaction. This policy is in stark contrast to the rate hike campaign in 1994. The Fed raised the federal funds rate from three percent to six percent in just 12 months. To make matters worse, most moves were not subtle. On May 17, 1994, Greenspan bumped the rate by .5 percent. In August, he bumped it again by another half. Then, in November, he had the gall to bump it up again -- that time by .75 percent. And then to make matters even worse, the Fed was secretive. As I said, markets hate surprises. It's no wonder the Fed's action contributed to several economic failures back then, such as the bankruptcy of Orange County, California. Let's get back to the present day. Long-term mortgage rates actually fell after the Fed made its latest announcement. Why would long-term rates fall in response to an increase in short-term rates? Thirty-year mortgage rates are governed by market forces -- basically supply and demand. Institutional investors buy fixed-rate investments such as treasury bonds and mortgage backed securities. When the demand for these investments increases, the price of the investment will increase. This results in the yield, or rate, dropping. Similarly, if the Treasury Department decides to flood the market by issuing new 30-year bonds, for example, supply rises, causing the price to drop and the yield to rise. So why, then, would a widely anticipated rate hike by the Fed cause an increase in demand of long-term bonds and mortgage securities? The answer is simple. The Fed has made itself very clear in its intent fight inflation by increasing rates as necessary. Inflation erodes the value of long-term interest rate investments, such as mortgage backed securities. In other words, nobody wants to invest in bonds and long-term mortgages during an inflationary period. Since the Fed is sticking to its inflation-cautious policy, investors figure that they'll be safe by buying these instruments, increasing demand. Eventually, however, long-term rates are likely to rise if the Fed continues to raise short-term rates. The logic is simple: borrowers are prepared to pay more for a fixed-rate loan because interest rate volatility is eliminated. Investors, likewise, will demand a higher yield if the yield has no chance of increasing in the future. Logically, short-term rates should always be lower than long-term rates. Long-term mortgage rates will continue to be influenced by economic news in 2005. If the Fed fails at its goal of staving off inflation, you can bet that mortgage rates will rise quickly. On the other hand, if the economy appears to be slowing down, mortgage rates are likely to fall. Who knows, the Fed could reverse course and start lowering short-term rates. Stay tuned, it should be an interesting year. |
