The Associated Press reports that mortgage rates are back up to where they were in August 2007. How can that be? After all, since then, the Fed has cut its Fed Funds rate from 5.25% to 2%. I guess Federal Reserve Chairman, Ben Bernanke's effort to forestall another Great Depression by flooding the zone with more debt has fallen victim to the law of unintended consequences.
While his efforts have not loosened the credit crunch, they have succeeded in boosting inflation to levels not seen in decades. And isn't that exactly the thing that the Fed is supposed to prevent? I was stunned to see that, as AP reported, the rate on 30-year mortgages hit 6.63% this week -- up significantly from last week's 6.26%. It hasn't been that high since August 1, 2007 -- when it hit 6.68% -- before the Fed started cutting rates.
This makes me wonder whether the Fed would have been better off leaving rates at 5.25% last fall. If so, it is likely that inflation would have remained lower instead of spiraling out of control and driving gasoline prices over $4 a gallon, tripling food prices and putting those who are paying now to heat their homes this winter into sticker shock. Simply put, the Fed rate cuts have not uncrunched credit but they have boosted inflation.
The reason mortgage rates are so high is that lenders perceive a much higher risk than before of not getting paid back. Moreover, the market for mortgage backed securities has dried up, which means that there is far less capital available to finance mortgages. The credit crunch is happening not because the Fed Funds rate is too high, but because banks don't have enough capital to make more loans.
And here's the kicker. Since banks are running out of ways to raise external capital, it is beginning to look like they may have to rely on their own ingenuity to profit in new ways. One thing that might help is stronger economic growth. But that won't happen as long as consumers' incomes are flat and their costs are rising. The Fed could help out consumers by raising interest rates, since those higher rates would reverse the rising costs.
How so? Many commodities, such as oil, are traded in dollars. The 72% drop in the dollar since January 2001 has contributed to the rise in oil prices. If the markets perceive that the Fed is willing to fight inflation, the dollar would strengthen. This would help reverse price increases and make the limited dollars coming into consumers' bank accounts more valuable.
Despite its rate cuts, credit is still crunched, but raising rates would strengthen the dollar -- and that would boost the 70% of GDP growth that flows from consumer spending.
Peter Cohan is President of Peter S. Cohan & Associates. He also teaches management at Babson College and edits The Cohan Letter.
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Waiting for the other shoe to drop: The looming credit crisis
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Reader Comments (Page 1 of 1)
7-25-2008 @ 11:24AM
Michael Schneider said...
You are correct that lower rates have not worked as expected to ease the credit crunch. However, oil and commodity prices have been correcting so the solution of raising rates most likely won't help that much if at all-- though many commentators have been talking up this approach. It is the housing slide that is the centerpiece of the fine mess we are in and the way to get out has to involve housing directly. That means just letting prices fall and allowing the pain to work its way through the system or providing direct aid to the housing industry. Any aid to the industry should be balanced to help both buyers and sellers-- rather than just propping up home prices and greedy speculators who created the problem. The recent bill that is expected to go through Congress and be signed by President Bush does have some help for potential home buyers and hence will be a useful step. It includes a tax credit for first time home buyers but the credit has to be paid back so the amount of help is limited. There is also a extra $500 deduction for those who don't itemize which seems directed at a small number of fairly wealthy buyers who will pay off most of their homes in cash and really don't need an extra $500. Ultimately, policymakers may have to revisit the housing issue and perhaps take a clearer view of what will help and what is just a handout. In the meantime, solutions like the tax rebates this spring have helped the economy short term but have not helped the longer term picture. My view has been that the economy will be in a slow period that will last much longer than people expect but will not be as deep as people expect-- so far this has been borne out. Also, the economic slowdown is the main threat- not inflation- and this view has been borne out also as oil and food prices are stabilizing.
7-25-2008 @ 11:27AM
beanspants said...
You don't think that banks are using the current spread to mitigate their mortagage losses, and that if the Fed hadn't lowered rates, then they would still be charging around 3% above prime on mortgages for the same reason, meaning current mortage rates would be around 8% APR?
Think about what that would have done to the housing markets, considering it is crashing and burning at 6% APR.
And think what troubles banks would be having if they didn't have that 3% cushion. I'd assume the bank failures would be much worse.
Yikes.
7-25-2008 @ 12:45PM
Kent said...
This is one time supply side economics isn't working. I suspect credit crunches are still in place despite Fed interest rate declinations. It is not passed on to the consumer but rather adds margins to banking institutions. I agree with Peter on this one: why need to have the Fed lower interest rates when it isn't jump starting the economy as intended? Let's take our lumps and raise interest rates and add income on deposits to jump-start our spending.
7-25-2008 @ 1:13PM
Steven Bote said...
Put simply, mortgage rates aren't tied to the overnight Fed rate, or the discount rate, or the treasuries--they are tied to their respective Fannie and Ginnie Mortgage-Backed Security Bond coupons.
And like all bonds, any indication of inflation in the current mix of economic data de-values the returns of these bonds, and hence is a catalyst for them getting sold off, which lowers their dollar price.
It's in this specific action that causes mortgage interest rates to fluctuate.
MBS bond-friendly news, such as the assistance of the Fed to support GSEs FNMA and FHLC bring about investors of such bonds, which ups its sale, price and demand.
MBS unfriendly news, such as the New Homes Sales only being down by a margin less than what speculators were expecting, can spark a sell off, and that's when rates climb up.
7-25-2008 @ 1:32PM
bj said...
with interest rates going even higher..for home loans..how does the banks ever think they can get out from under this mess??? just an idea
7-25-2008 @ 2:03PM
beanspants said...
Steven, while your comment is technically true, it attempts to show that these systems as decoupled and independent, but the reality is they are very tightly wound together.
7-25-2008 @ 2:48PM
william lindblad said...
Well, they used to reflect the 10 year bond and it's pretty hard to tell what they are based on these days. If you want to put a case for Ginnie and Fannie, than you should be able to fit this with these two at three years ago. In truth, it is more in the realm of how much cheap money is available and how competitive the market. That was the case 3 years ago when every mortgage broker and lender was out to get everything that they could. You are not taking into account all of the points, fees and miscellaneous charges. Getting a true picture is not always that easy.
If the is a real reason to jack rates, it is the fact that the lenders have a great deal of loss to make up. You can merrily search for a variety of other reasons, but this one prevails. Anyone that is a doubter has all but to look to the insurance industry. If thy make investment mistakes, rates rise. If they are hit with large payouts due to any event, natural or otherwise, rates always rise. If they need more profit, rates rise. This is capitalism. The only one complaining is the whining
consumer.
7-27-2008 @ 8:21PM
gumbo koontz said...
You can listen to experts but dont always follow them in their footsteps.. make your own trail.