Who controls interest rates?

There were a couple of blurbs in the Austin American-Statesman last week about the Fed and interest rates.  One day the Fed indicated they were holding rates steady.  The next they told banks to prepare their businesses for the prospect of higher interest rates in the coming months.  The point of my post here is that neither of those announcements had much, if anything to do with MORTGAGE interest rates!

The purpose of the Federal Reserve System is to control the levers of monetary policy — i.e., controlling how much of our currency is actively circulating in the economy.  (You often hear discussion of them controlling inflation.  The tool they use is monetary policy.)  They do that by setting rules about the amount of reserves that banks are required to hold, and by establishing two “base” interest rates:   (i) the discount rate — what banks pay to borrow money from the Fed; and (ii) the federal funds rate — what banks pay for overnight loans from other banks.  Both concern what banks pay for extremely short-term loans.

Mortgage interest rates, however, are determined by the market — alternative investments available to people and institutions looking for places to put money for the long term — ten years or more.  If you want to “park” investment funds for ten years, the safest place to do that is in 10-year Treasury bonds.  Historically, T-bills have been true “no risk” investments.  They are sold at auction, and the yield of each bond is determined by how much below “face value” it sells for.  The nature of “rational” markets is that low risk investments offer low return.  Investors who want to earn more on their money must make higher risk investments.  One of the alternatives is buying mortgage notes or bundles of mortgages.  In any group of 100 mortgage loans, a percentage will not be repaid.  Because of that risk of default, mortgage investors demand a premium over the rate of return they could get on long-term T-bills.  If the yield of Treasury bonds increases and/or the risk of default in the mortgage business goes up, investors will require a higher return.  In order to keep selling their mortgages (so that they have money to make more loans), banks must charge higher mortgage interest rates.

That last point is the important one.  Many people hang on every report from the Fed, and their activities can have huge impact on our overall economy.  They do not, however, manage mortgage interest rates.  Mortgage professionals watch weekly auctions of long-term Treasury bonds (and other long-term investment alternatives) to gauge the direction of mortgage rates.  If you have time to monitor bond auctions, more power to you.  But …

if you are actively in the market for a home, and will need a mortgage loan to make your purchase, a very early step should be forming a relationship with a well-recommended mortgage professional — one whose advice and counsel you can trust.  There are several that I have worked with on my website.  Feel free to call any or all of them.  The only thing I gain if you work with them is the confidence that they will do what they say they will do — thoroughly, professionally, and on time.