Trick for Treat: Mortgage Rates Defy Federal Funds Rate Cut
To much fanfare, the Federal Reserve cut interest rates on October 29th. That was supposed to be this week’s Halloween treat for the markets. The trick came the next day, when Freddie Mac’s survey of mortgage rates revealed that 30-year rates had risen sharply for the week.
So what gives? A clue to why market rates moved contrary to the federal funds rate could be found in two other pieces of news:
- The housing market continued to be weak, as one survey of major housing markets saw prices extent their slide to 25 consecutive months
- The U.S. dollar showed signs of weakness which were exacerbated by the cut in federal funds rates.
For the time being then, despite the Fed’s actions, things got tougher for borrowers rather than easier. This highlights some realities of what the Fed can and cannot do.
Limits on the Effectiveness of a Rate Cut
There are several reasons the effectiveness of Fed rate cuts are limited in the current situation, and two of them were apparent last week. First, consider the continued slide in housing prices. House prices have gotten cheaper, and mortgage rates have been relatively low in recent months. Why then, has this failed to generate more borrowing and stronger housing demand?
While the reluctance of banks to lend is part of the story, it is likely that people are equally reluctant to borrow. Households are overextended, and with a slowing economy, many people are afraid of losing their jobs. Borrowing demand in such a climate is bound to be weak, so in this context the Fed lowering interest rates is an example of what economists call “pushing on a string.”
Then there is the U.S. dollar. The mounting level of U.S. debt as the government throws money at the financial crisis is worrisome to international investors, and a cut in federal fund rates only makes the dollar less attractive. A weak dollar drives investors away from U.S. bonds, and also has an inflationary impact. Both of these serve to drive market interest rates up.
What the Rate Cut Might Do
So the cut in federal funds rates has not stimulated borrowing demand, and it might actually have contributed to driving market rates up. Still, this is not really about market rates. The federal funds rate is not an open-market rate, but rather the rate at which financial institutions can borrow money from the government. By making money cheaper to those financial institutions, even while market rates remain unmoved or rise, the Fed is making lending more profitable for those institutions. This may eventually loosen up lending practices, and in the meantime it will help shore up bank balance sheets.
Call this a silent bailout. While not as splashy as the $700 billion dollar package passed recently, it is not cost-free either. Lending at a lower rate costs the Treasury some money. Meanwhile, the public pays in the form of inflationary pressure and, as we saw this week, higher market interest rates. All of this may eventually work, but it certainly won’t be an easy fix.
Tags: borrowing, fed, federal funds rate, Federal Reserve, freddie mac, house prices, housing market, housing prices, mortgage, mortgage rates
