Today saw a rare move lately from the Fed: a stated intention to move interest rates higher. The move is so unusual because we have recently seen some of the lowest interest rates in the Fed’s history in an attempt to boost economic activity. Now, under the umbrella of some economic optimism, the independent board is set to move interest rates higher in an attempt to get ahead of inflation.
And so the media begins its occasional attempt to explain the move’s impact to laymen in ways that might affect every man. Target #1: mortgage interest rates. But we also know that we don’t directly borrow from the government, so how exactly does an independent monetary policy decision shape the borrowing costs for millions of Americans? Let’s explore the series of events that brings us from Fed rates to Mortgage rates.
*Side note: I studied a lot of economics in college, but I would hardly call myself an economist, so bear with me as I explore this issue in a less-than academic manner
Step 1: Monetary Policy
Monetary policy, in short, describes a government’s efforts to control the supply of money in an economy. Why does supply matter? Well, increase the supply of money, and you can force a little more oomph from the increased spending power you give to your citizens. Maybe some businesses decide to invest a little more. Maybe a family can now afford a vacation. More money = better for economic activity.
But wait, if every government in the world started boosting the money supply it would create mass inflation – the killer of economic power. Countries like Venezuela can tell just how disastrous inflation can be on an economy. Think useless $100 bills that are used for heating fuel instead of paying debts! Inflation is a beast best left at around 2% a year, which happens to be the exact level The Fed targets.
So how should an economy decide to walk this line between economic growth and inflation? The US Government does so by organizing The Federal Reserve (a.k.a. “The Fed”)- a fancy name for an board of stodgy economists, who at the end of the day, really only care about striking this balance correctly (they also are fiercely independent of politics because, duh, nobody blue or red should be influencing something as important as monetary policy).
Step 2: The Federal Reserve Rate
The main tool that The Fed wields is the Benchmark Interest Rate; the rate that banks use to borrow terms term cash (it’s actually slightly more complicated than that, but honestly not worth diving into). Consumers are not allowed to borrow at this rate. But banks are heavy users of this credit facility for a couple of reasons: 1) It’s usually way cheap, and 2) They need to keep a reserve of cash every day because the government requires capital reserves in order to avoid 1929(or 2008)-style bank runs.
For the past decade, this rate has been at or around 0. Free money! (not really, but almost). The idea has been to encourage banks to lend out this money at low rates, boosting economic activity. Recessionary forces have kept inflation largely in check as The Fed has been lending at such a low rate.
Step 3: Mortgage Rates
Mortgages are a big way that American banks lend their money. And banks can lend their money out from many sources of capital. One of the most obvious is deposits on customers’ own money. But another source is debt from the government via the Benchmark Interest Rate.
In fact the federal reserve rate has not even risen yet, but the anticipation of higher rates have driven the average mortgage rate from about 3.5% APR to over 4.0% APR. This not sound like much, but on an average Texas home, worth say, around $250K, a half percentage hike can amount to an extra $85 a month in mortgage payments. That also means an extra $38K on the total cost of the loan!
This scenario also plays out with some credit card debt and consumer vehicle debt. Virtually all debt in the US is effected, at least in a small way, by The Fed’s moves. But just before you start organizing the mob and grabbing pitchforks, it’s worth putting some historical perspective on the current Fed rates. They’re still low. Very low. So, mortgage industry, let’s be happy that we’re not living in 1980 when homeowners were paying over 18% APR on their homes loans!
Special thanks to Redfin for letting me learn and use their excellent economic reporting.