This week, Gail explains how the Federal Reserve's much-publicized rate reductions affect our everyday financial lives.
Could you please explain how when the Fed lowers the interest rate it affects other rates (mortgage, auto, CDs etc).
The reason I ask is for the past few months, I've been watching the mortgage rates and when the "Fed" initially lowered its rates, the mortgage rates came down. But mortgage rates seem to have hit a plateau. They haven't continued to come down even though the Fed kept lowering its rates.
Great questions! The Federal Reserve ("the Fed") doesn't have the power to order banks or credit card companies to charge a specific interest rate. That's why a lot of companies — department stores, in particular — are still gouging us to the tune of 18-21% on outstanding credit card balances.
They get away with it because consumers put up with it. It's a free market, so if you don't like their terms you can simply stop using their charge cards and switch to one offered by another, less expensive, credit card provider.
Once you understand that interest rates are set, not by some government entity, but by the law of supply and demand, it's quite apparent why they move in one direction or another: Interest rates are simply a reflection of how much money is available for lending and how badly people and companies want to borrow it.
As our nation's central bank, the Federal Reserve only has the power to influence interest rates in an indirect way using one or all of the following methods:
1. Raise or lower the "reserve requirement." All banks are required to keep a minimum amount of cash on hand. based on a percentage of their total assets (checking account balances, etc.). This is calculated on a daily basis.
If the Federal Reserve raises the reserve requirement, then banks have to set aside more money. Cash that is tied up to meet this higher reserve requirement is not available for other uses — lending out, for instance. Since this "reserve" cash is earning zero, banks will respond by raising the interest rates they are charging borrowers in order to make up for the loss in income.
Lowering the reserve requirement has the opposite effect: it frees up cash, making more available for banks to put to other uses. But since all banks now have more money to lend, they have to compete for your business. Usually they do this by lowering the interest rates they're charging.
2. Increase or decrease the "discount rate." This is the interest rate the Federal Reserve charges banks when the banks themselves need to borrow money. This might occur if, for instance, a bank couldn't meet its daily "reserve requirement."
Let's say that on a single day a bank found that an unexpectedly large number of people cashed checks, withdrew money from its ATMs, and a several corporations borrowed millions of dollars.
At the close of business, the accountants figure out that the amount of cash the bank has in "reserve" is less than the amount required. Oops. This is not negotiable. Either a bank is in compliance or not.
On a smaller scale, it's the same principle that the bank follows with you if you have an account that you must keep at a certain minimum balance. If falls below this amount for just one day you're hit with fees and penalties.
In order to close each day with the proper amount of cash in its "reserve" account, a bank could borrow what it needs from the Federal Reserve. The "discount rate" is the interest rate the Fed would charge for this 24-hour loan. That's why this is often described as an "overnight" lending rate. Just as with any other business, costs incurred by a bank are passed along to customers, often in the form of higher interest rates. On the other hand, if the bank pays less for its overnight loan, then rates to customers should fall.
Notice that banks are not required to change the interest rates they charge borrowers just because the rate they have to pay goes up or down. However, if they want to remain competitive, they will make these adjustments.
3. Increase or decrease the "federal funds rate." If a bank needs to borrow money to meets that day's reserve requirement or to be able to make more loans, it doesn't have to get this cash from the Fed. Instead, it could borrow it from another bank. The "federal funds rate" is the minimum interest rate the Federal Reserve requires banks to charge on loans to each other.Again, the same principles apply in terms of how this translates into consumer loan rates.
4. Increase or decrease the supply of money. Through its New York branch, the Federal Reserve conducts what are called "open market operations." This simply means the Fed either offers to buy or sell Treasury securities, competing with other investors in the market.
If the central bank offers to pay slightly more than the going price for, say, 5-year treasury notes, then a bank might decide to sell them back. When it does, the bank gets cash in return, cash that it can turn around and offer to borrowers. The result is, when the Federal Reserve Bank buys securities — and we're talking billions at a time — it is increasing the supply of money. If the demand for borrowed money holds constant, increasing the supply will bring down the cost, i.e. interest rates.
On the other hand, if the Fed wants to nudge interest rates higher, it will sell Treasury bills, notes and bonds at rates high enough that banks are attracted to buy them. (Given the choice of earning 5% risk-free from the government versus 7% on a car loan someone might skip out on, which would you take?)
To pay for these government securities, banks have to turn over cash. So the end result is that money is drained out of the system. Without a proportional drop in demand, a reduced supply of anything — chickens, Haz-Mat suits or cash — translates into higher prices. When you're talking about money, the higher price you pay is the interest rate.
Now that you've waded through all that, why do you think mortage rates have not continued to follow the fed funds and discount rates lower? (Hint: try "demand".) As mortgage rates decline, more people are able to qualify for loans. Thats why home ownership is at an historically high level. However, at some point, there is so much demand, lenders don't have to lower their rates to get business.
There's also another reason: uncertainty. From the consumer's vantage point, banks and mortgage companies look like "lenders." But from their point of view, they are "investors" -- that is, they are expecting a certain return (the interest rate) in exchange for the use of their money over a certain period of time.
However, as interest rates fall, consumers are more likely to refinance. This involves paying off an existing mortgage early and getting a new mortgage at the lower rate. So an investor who expected to receive a return of, say 7% for 30 years, suddenly gets his money back much sooner and loses the income he had counted on. The rates on long-term mortgages are higher than you might expect in order to compensate the investor/lender for this prepayment risk.
Finally, one more factor. Most of the monetary strategies available to the Federal Reserve only have an impact on short-term rates. Most mortgages are long-term commitments of 30 years or so. Rates on short-term mortgages such as 5-year adjustables, have fallen dramatically. It's the long-term, fixed-rate mortgages — which, again, involve pre-payment uncertainty — that seem to have leveled off at around 6-6.5%
Warning! This is by no means a complete or perfect description of how the Federal Reserve influences interest rates-- countless books have been written on this subject. And I encourage you to read them if you're so inclined. :> But hopefully, this gives you a better understanding of the basic concepts and terms.
Believe it or not, much of this essentially boils down to good old "supply-versus-demand!"
If you have a question for Gail Buckner and the Your $ Matters column, send them to firstname.lastname@example.org along with your name and phone number.
The views expressed in this article are those of Ms. Buckner or the individual commentator, and do not necessarily reflect the views of Putnam Investments Inc. or any of its affiliates. You should consult your own financial adviser for advice regarding your particular financial circumstances. This article is for information only and is not an offer of the sale of any mutual fund or other investment.