- The Washington Times - Friday, September 28, 2007

Responding to growing concern over the health of the economy and the ongoing credit crunch, Chairman Ben Bernanke and his band of policy-makers at the Federal Reserve Board cut two key interest rates by 0.5 percent.

On Sept. 18, the Fed cut the federal funds rate to 4.75 percent. This is the rate banks charge each other for overnight funds to meet the Fed’s reserve requirements. It also lowered the discount rate by 0.5 percent to 5.25 percent. This is the rate banks are charged when they borrow directly from the Federal Reserve.

As usual, I received a handful of calls from clients expecting to lower their mortgage rate with refinancing. The problem is that the federal funds and discount rates are very different financial instruments from long-term mortgage rates.

Though a Fed policy of easing credit by lowering these rates should eventually influence mortgage rates, there’s never any guarantee that mortgage rates will move in tandem with short-term rates.

In fact, long-term rates have risen modestly since the Fed announcement. Here’s why: Short-term rates are governed by the Federal Reserve, while long-term rates, such as Treasury bond yields and 30-year fixed-rate mortgages, are governed by market forces.

Apparently the market feared the Fed’s larger-than-expected rate cut could put inflationary pressures on the economy. Inflation erodes the value of long-term financial instruments such as Treasury bonds. There was a mild sell-off in Treasury bonds, which lowered the price and raised the yield. Bond prices and yields move in opposite directions.

One reason I have tried my best to stay away from predicting what long-term interest rates will do over the short term is that there are too many influential factors. Two days after the Fed’s cuts, long-term rates continued to rise because of speculation that Saudi Arabia would lose its appetite for Treasury bonds, thereby reducing demand and causing bond prices to drop. This speculation caused another mild sell-off.

I also try to stay away from predicting what long-term rates will do over the long term. However, one can’t help but notice the economic trends that have emerged recently. Here’s what I am seeing:

• A pretty severe housing slump.

• A continuing decline in home construction. The National Association of Home Builders recently said confidence among builders fell to its lowest level in the 22-year history of its housing index.

• A significant credit crunch that is likely to last a bit longer.

• The first drop in payroll jobs in four years.

All this spells weaker economic growth. Weak economic growth usually leads to lower long-term interest rates. Remember, this is not a prediction, just an observation.

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

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