- The Washington Times - Thursday, September 30, 2004

Last week, Federal Reserve Chairman Alan Greenspan and his board of policy-makers made the

widely expected move of raising the federal funds rate by a quarter percentage point to 1.75 percent.

This is the short-term rate that banks charge one another for overnight funds. It is wholly controlled by the Fed. Banks around the nation responded to the move by raising the prime lending rate to 4.75 percent from 4.50 percent.

We can now expect to pay a little bit more interest on credit-card debt, home-equity lines and other consumer loans.

What’s interesting, however, is the bond market’s reaction to the Fed’s decision. Treasury bonds are government-issued debt, and investors buy and sell Treasury bonds in the open market. When bond prices rise, the yield falls, and vice versa. Long-term mortgage rates are closely tied to Treasury bonds, so mortgage rates typically move in the same direction.

I probably received a dozen calls last week from clients who had assumed mortgage rates spiked as a result of the Fed’s move.

Well, for the record, the Fed cannot raise long-term mortgage rates. The rates are governed by market forces, similar to the yield on Treasury bonds. When the Fed decides to make a move with the federal funds rate, it is likely to get some reaction in the bond market, but not always the reaction one might expect.

The Fed’s move last week is a great example. Before the announcement, the yield on the 10-year note was hovering around 4.12 percent. One day later, the yield fell to 3.99 percent. Long-term mortgage rates, in turn, dropped.

When short-term rates rise and long-term rates fall, we have what’s called “flattening of the yield curve.” Basically, this means that short-term loans get more expensive and long-term loans get less expensive.

Here’s what I think is happening. Mr. Greenspan has always been an inflation fighter and has rarely hesitated to raise rates if inflation or the worry of inflation appears.

Earlier this year, economic growth was clocked at a brisk 4.5 percent annual rate — brisk enough for some to worry about future inflation. So the Fed sets a policy of modest and measured increases in short-term rates just to make sure inflation doesn’t rear its head.

Later in the year, growth sputtered to a lethargic 2.8 percent annual rate. That didn’t make Mr. Greenspan alter his policy. In fact, he called the slowdown in growth a temporary “soft patch.”

Summer goes by. There’s no significant core inflation and no data to suggest that the economy is on fire.

It’s important to point out that the value of bonds deteriorates during periods of inflation. Bond investors begin to believe that the economy isn’t roaring back to life and inflation is being kept at bay, so they buy more bonds.

The price goes up, and the yield falls.

Mortgage rates follow.

I think investors are buying bonds and causing long-term interest rates to drop because they are not as optimistic about the economy as the Fed is.

If the demand for bonds remains high and the Fed continues its course of raising short-term rates at a measured pace, the yield curve will continue to flatten.

This is good news for the mortgage market. The last time the yield on the 10-year bond was as low as 3.99 percent, I was up to my neck in refinance business. Homeowners might want to check their mortgage notes. Another refinancing miniboom might be imminent.

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

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