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New Fed Tactic Triggers Dramatic Drop in Mortgage Rates

This week’s mortgage news was dominated by a dramatic drop in mortgage rates triggered by a new Federal Reserve approach to the financial crisis.

Of all the actions taken to address this crisis, none has had such immediate and tangible effects. Neither lowering Fed rates nor providing direct financial support to lenders seemed to make so much as a ripple in the credit markets. However, on news of this latest Fed program, 30-year mortgage rates dropped the better part of a full percentage point, falling near their all-time lows.

The Fed has announced that it will buy $600 billion in existing, mortgage-backed debt. This move both frees up capital for new lending, and gives lenders renewed confidence to make loans. It is the latter especially that accounts for the immediate drop in interest rates.

It is worth a closer look at what this action will and won’t accomplish, but in the short term it is undeniable that it has created a rare opportunity for home buyers and people who want to refinance. 

What the Fed’s Action Won’t Do

What the Fed’s action won’t do is instantly shock the economy back to life. It is important to note the strength of the tide the government is working against. In the same week that the new Fed program was announced, there was also news that the economy had contracted in the third quarter of 2008 by more than had been previously thought, consumer spending was down 1% in October, and the housing market posted yet another record year-over-year decline.

The program to buy up mortgage debt is designed to stimulate lending, and like other Fed policies designed to do the same thing — most notably, the repeated cuts in interest rates — it may become an example of what economists call “pushing on a string.” This means that it is futile to stimulate supply (in this case, lending) if demand isn’t there. It is clear that consumers have lost some of their taste for borrowing.

That’s not all bad. On average, U.S. consumers were at high debt levels, and a cooling off period is necessary to get balance sheets back in reasonable shape. Old-fashioned belt-tightening is not conducive to a quick economic recovery, but it does set the stage for a longer recovery eventually. In the meantime, relief in the form of lower mortgage rates should hasten this process of easing the debt burden for a great many households.  

What the Fed’s Action Will Do

From a macro-economic standpoint, that’s the best that can be hoped for from the Fed’s action: not an immediate cure-all, but something that will help along the natural progression of the economic cycle. If those lower mortgage rates stick, it should certainly help.

Getting away from the macro-economic perspective for a moment though, things are much clearer at the individual level. Anyone with a mortgage above 6% should look into refinancing at the new rates. Also, potential home buyers who have decent credit, a little savings for a down payment, and stable income should look at this as a truly rare opportunity. With home prices down and mortgage rates near all-time lows, it is hard to imagine what else any eligible buyer would need to get into the market.

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