- The Washington Times - Wednesday, November 17, 2004

Last week, Federal Reserve Chairman Alan Greenspan and his Federal Reserve Board made a widely

anticipated decision to raise short-term interest rates by a quarter of a percentage point.

The Fed has direct control over two rates: The federal funds rate, which is the overnight bank lending rate, and the discount rate, which is the rate the Fed charges for loans it makes directly to banks.

The Fed raised the federal funds rate from 1.75 percent to 2 percent, and it raised the discount rate from 2.75 percent to 3 percent. The reaction in both the stock and bond markets was muted, probably because the move was anticipated, eliminating any surprises.

What’s interesting is that the U.S. Treasury bond market, which moves closely with fixed-rate mortgages, improved slightly on the news. Contrary to the widely held belief that a Fed interest-rate increase spills over into the mortgage arena, it is never certain that such a move will cause mortgage rates to rise.

The Fed controls short-term interest rates, and I mean really short term. We’re talking about 24-hour interbank loans. This is a completely different instrument from 30-year fixed-rate mortgages. It’s like comparing apples grown in California to oranges grown in Florida. They don’t have a whole lot to do with each other.

Mortgages rates tend to move on economic news and other unanticipated information. The Fed’s official statement after the policy meeting was nothing but the same old same old. The Fed is “optimistic” about the economy and can continue to raise rates at a “measured” pace. Inflation and longer-term inflation remain “well contained.” The Fed did not surprise the bond market.

The Fed’s job is by no means easy. If it raises rates too much or too quickly, economic growth gets stifled and the economy becomes anemic. If it keeps rates too low, the economy begins to overheat and price and wage inflation become a danger.

The Fed’s goal is to strike a balance — moderate healthy growth with contained inflation.

Mortgage rates, which are governed by market forces, tend to rise if inflation becomes a threat or the economy is perceived as overheating.

By the same token, long-term rates typically fall when poor economic news is announced, because a slow economy usually suggests inflation is under control.

The only thing that one may predict is that the yield curve is continuing to flatten.

That is, short-term interest rates, such as monthly and yearly adjustable mortgages, are rising while long-term mortgages, such as 30-year fixed-rate loans, are remaining stable.

The Fed has made it clear that it intends to continue to nudge up short-term rates.

Long-term rates are likely to continue to blow with the economic wind. If the economy strengthens, long-term rates will probably rise.

If the economy sputters, rates might drop and another refinancing wave will be among us. Stay tuned.

Henry Savage is president of PMC Mortgage in Alexandria. Contact him by e-mail ([email protected]).

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