We know the headline makes no sense, but bear with us because it’s true. To understand this, you have to understand that the Feds (technically the Board of Governors of the Federal Reserve Bank, also known as the Federal Open Market Committee) only control short-term rates – the Federal Funds Rate and the Discount Rate. Long term rates often react to this by moving in the opposite direction, and so the Feds raise interest rates in order to lower them.
Not what, why? Let’s start with why the Federal Reserve messes with interest rates at all in the first place. The Federal Open Market Committee has two objectives: maintain full employment and keep inflation under control. These are conflicting goals, because if unemployment goes too low (or, more accurately, employment goes too high) then inflation invariably follows, because employers have to compete for good employees, which drives up wages, which drives up prices.
The Feds can make it cheaper or more expensive for businesses to borrow money to use to expand by influencing (not directly controlling) the interest rates that banks have to charge their business clients. Since they can’t directly control what businesses charge, they instead use their tools to influence what money costs banks, and that directly influences the interest rates banks charge their customers.
They do this with two interest rate settings. The Discount Rate is the interest rate that the Federal Reserve charges banks to borrow money overnight. Why would a bank do that? They are required by law to maintain a certain level of reserves, measured as a percentage of their total deposits. At no time may a bank lend out 100% of the consumers’ money it holds on deposit, because every day some folks will want to withdraw their money, and the bank has to have it to give it to them.
On days when they fall below their required minimum, a bank needs to borrow the difference overnight to meet the requirement. They can borrow directly from the Federal Reserve, through the Discount Window, or…
They can borrow from other banks. The other short-term interest rate that the Federal Reserve influences (but doesn’t control) is the Federal Funds Rate, which is a target that the Feds set for banks to lend money to each other overnight. Naturally, while some banks fall short of their reserve requirements, others exceed them, and it allows those banks to earn a little bit on their extra money they have sitting in a vault.
I get the what, but why?
I’m getting to that. Remember that the Feds have two conflicting goals: to maintain full (or close to full) employment and the keep inflation low. If the economy stalls out, then unemployment will rise and people will be out of work. That’s bad. If they lower short-term interest rates they encourage businesses to borrow more because the money is easier and cheaper. The result is more expansion of business, and therefore the economy.
On the other hand, if the economy gets too strong and heats up so much that inflation appears imminent, the Feds might raise short-term rates and discourage lending, thus slowing down business growth and therefore, the economy.
Where is the connection?
Long-term interest rates are driven primarily by one factor – inflation, or rather the expectation of inflation in the future. (Why? Read this.) If institutional investors think inflation will increase, they have to demand a higher return on their investment – and thus ask for higher interest rates on loans. However, if they see that the Federal Reserve is fighting inflation by aggressively raising short-term rates to slow down the economy, their expectations of inflation decrease, and they can accept a slightly lower yield.
It isn’t exactly true that the Feds raise interest rates in order to lower them, so we apologize for the misleading headline. It would be more accurate to say that the Feds raise short-term rates in order to slow down the economy, and that is likely to lead to lower long-term interest rates, like mortgages.
The take-away, however, is the same. When the Feds raise interest rates, don’t panic! Yes, it will increase the cost of your credit card debt, but you shouldn’t be carrying that from month to month anyway. On the other hand, if you are in the market to buy a car, or a home, or borrow to fund your education, you may be pleasantly surprised when the Feds raise interest rates in order to lower them.
This article represents the opinions of Casey Fleming, and not necessarily those of C2 Financial Corp. This analysis was prepared with the best information available at the time it was written. Neither Casey Fleming, nor C2 Financial Corp., have any magical insider information about bond markets, real estate markets or mortgage markets that would make economic projections any more reliable than any other source. No warranty is made that the outcome will reflect the projections in this article, and neither Casey Fleming nor C2 Financial Corp. are responsible for decisions that you make regarding your own choices about your real estate or mortgage or those of your clients.
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