The first thing that might jump out at you about this headline is I did not ask “When will the Feds raise rates,” but “How.” Interest rates are going to rise sharply, and fairly soon. But it’s not why – or when – the radio ads would have you believe.
You’ve probably been hearing lots of ads recently that you need to refinance as soon as possible, because the Feds have been talking about when they will raise interest rates. These ads have been tied in to lots of stories about the Fed meetings, the release of the minutes from those meetings, and the public comments of the individual members. And of course, when Janet Yellen talks, people listen. (Just like Ben Bernanke before her, and Alan Greenspan before him.)
The purpose of this article is to let you know that yes, interest rates will go up eventually, and they will rise in large part due to actions by the Federal Reserve. However, it will have nothing to do with the short-term interest rates they “set,” and everything to do with the long-term interest rates that the market sets, but that they manipulate.
So, let me explain, and you can be the smarty-pants at the next cocktail party. You know, the know-it-all that generally sits by himself. You’ll learn to live with it, I swear. Oh, back to the point at hand:
The only interest rate that the Federal Reserve (Feds) actually “sets” is the Discount Rate. When banks need to borrow money because they are short on cash (yes, that happens) they may borrow that money for a short term from the Federal Reserve. The Feds lower this rate during tough economic times in order to inject liquidity into the banking system. The theory is that if banks can borrow money at a very low interest rate, they will lend it out at low rates too, and thus inject money into the economy via borrowing, mostly by businesses.
This didn’t work as well as hoped during the financial crisis because rather than lending the money out to businesses banks generally invested the money elsewhere where it had less of an impact – or none at all – on cash in circulation in the economy.
So the Feds began their program known as Quantitative Easing, or QE. Through this program, the Feds purchased U.S. Treasury bonds, the instrument by which the federal government borrows money. At the peak, they were purchasing $40 billion a month in U.S. treasury bonds. The theory was that by giving the government money to use for deficit spending more money would be injected into the economy. The expectation was that the money would be used for infrastructure projects and safety-net programs such as unemployment compensation, food stamps, and the like.
When that failed to goose the economy as expected, they began their QE2 program, where in addition to treasury bonds they were purchasing $45 billion a month in mortgage-backed securities. They were, in essence, buying up almost all of the mortgages written in the U.S. at a yield (interest rate to you) that was much lower than other investors were willing to accept. The theory was that by driving mortgage interest rates down homeowners would refinance and more potential home buyers would buy.
There were several benefits anticipated from this:
- Financing activity would inject money into the economy through the mortgage industry.
- Purchase activity would inject money into the economy through the real estate industry.
- Homeowners who refinanced would have more disposable income, which they would spend, injecting even more money into the economy.
- Home buyers would spend money on their new home, injecting money into the economy.
And this actually worked. Once they began QE2, low interest rates generated a tremendous amount of economic activity which reverberated, as expected, through the rest of the economy.
In late 2013 the Feds announced they would stop using new money to purchase both the mortgage-backed securities and treasury bonds. To avoid a disruption in the market, they did not stop overnight, but rather tapered off their purchases over nearly a year, until they were injecting no “fresh” money at all into the system. Many feared rates would skyrocket, since private institutional lenders had shown no interest in bonds at yields that low, but that didn’t happen. Interest rates have stayed low.
We’re finally getting to the point of this article…
If private investors want higher yields than the current market offers and the Feds aren’t injecting any new money into the system, why have interest rates stayed low?
It turns out that while the Feds stopped investing any new money into the system, they are recycling the old money. They receive payments every month on the securities that they already hold, and as mortgages are paid off (for any reason) they receive the remaining principal balance of the mortgage as well. They are still using this money to buy securities, to the tune of as much as 85% of the available issues.
In other words, they are still buying up almost all of the market, and therefore still driving down interest rates.
When will the madness stop? Well, while they are being very transparent and public about their discussions regarding when they will raise the discount rate, they have been very quiet about this issue, and because it is complex and arcane, media has given it scant attention.
But some day they will need to start cashing in their holdings (which now amount to trillions of dollars) and when they do, interest rates will rise to whatever yield private institutional investors find attractive. Today that interest rate appears to be at least 1% higher than current going rates for mortgages, maybe more.
So, while the talk about the Feds raising the short-term rates (and thus driving up mortgage rates) is so much baloney, the Feds will indeed “drive up” mortgage rates (by ending the practice of diving them down.)
It is not a matter of if, but when, and “when” is indeed the question.
And now you know why I spend a lot of time by myself in the corner at cocktail parties.