- The Washington Times - Wednesday, December 22, 2004

Last week, Federal Reserve Chairman Alan Greenspan and his merry band of policy-makers

nudged rates up for the fifth time this year.

The federal funds rate, which is the rate banks charge each other for overnight loans, was raised to 2.25 percent. That’s up from 1 percent, a 60-year low, last June.

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.

Long-term mortgage rates fell slightly on the news, however. It may seem counterintuitive, but it’s important to remember that 30-year mortgage loans are different from loans that carry short-term rates, such as those tied to the prime rate.

Also, the prime is highly influenced by the Fed’s actions. When the Fed raises the federal funds rate, the prime rate follows.

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 to continue to raise short-term rates at a “measured” pace. Investors interpret this as a policy that will keep inflation at bay. 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. Because the Fed is sticking to its inflation-cautious policy, investors figure they’ll be safe. Presto. Demand increases and rates fall.

Eventually, however, long-term rates are likely to rise if the Fed continues to raise short-term rates. The logic: Borrowers are prepared to pay more for a fixed-rate loan because interest-rate volatility is eliminated. And investors will demand a higher yield if the yield has little chance of increasing in the future. Logically, short-term rates should always be lower than long-term rates.

What’s more likely to influence long-term rates in 2005 is economic news. If the Fed fails at its goal of staving off inflation, you can bet that mortgage rates will rise quickly.

Yet if the economy appears to be slowing down, mortgage rates will likely fall.

In fact, the Fed could reverse course. It should be an interesting year.

Henry Savage is president of PMC Mortgage in Alexandria. Contact him by e-mail (henrysavage@pmcmortgage.com).

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