How Does The Federal Reserve Affect Interest Rates?

by : Ed Jeffry

I would argue that the most powerful man in the world is not the President of the United States but rather the Chairman of the Federal Reserve Ben Bernanke. He is the modern day EF Hutton...when he speaks, everyone listens - even the President.

The Federal Reserve was founded by Congress in 1913 as the central bank of the U.S. The function of the Fed is to conduct the nation's monetary policy and regulate our banking institutions. Within the Fed is the Federal Open Market Committee. This committee consists of 12 members which includes seven members of the Board of Governors of the Federal Reserve System and the President of the Federal Reserve Bank of New York. The FOMC meets in person eight times per year and may meet by phone on other occasion. When major economic events occur, the FOMC may meet as they did after 9/11.

The FOMC achieves its fiscal objectives partially by setting the target for the federal funds rate which is currently at 5.25%. This rate is that which banks lend their deposits to other banks overnight. They do this to help other banks keep within the reserve requirements set by the Fed. The highest federal funds rate in the last 16 years was 8.0% back in 1990. It was at it's lowest just recently when it bottomed out at 1%. The Fed also provides information on the economy by publishing a report called the "Beige Book". This report is published eight times per year as well and is based upon anecdotal evidence gathered by each Federal Reserve Bank.

Here is how the Fed and Mr. Bernanke affect interest rates. They affect rates by lowering or raising the Federal Funds rate. There is a direct affect on short term interest rates like the prime rate and any kind of T-Bill rates of less than 5 years. Almost every bank mirrors the Fed with the prime rate they publish. In other words, as the Fed moves the Fed Funds Rate, banks move the prime rate. The prime rate right now is 3% higher than the Fed Funds Rate. So if the Fed raises the Fed Funds rate from its current level of 5.25% to 6.0%, then the prime rate would move from 8.25% to 9.0%. Most 2nd mortgages are based upon the prime rate, so as it moves so does the cost of credit to homeowners. Also, your credit cards are usually following the Fed when they move rates. You will find the least expensive credit cards when the Fed Fund rates are at their lowest.

The affect on long term rates are not as direct. If the markets perceive that the Fed is not being diligent against inflation then long term rates may rise. This is interpreted by the markets when the Fed Funds rate is lowered therefore attempting to stimulate the economy which could lead to inflation. This is the major reason that you may have noticed that 30 year mortgage rates have not increased dramatically over the last 2 years even though the Fed has raised rates 17 times. Long term rates will generally move the opposite way the Fed moves rates or at least move less dramatically, which is what we have seen over the last 2 years.

In a recent report released, it was stated that a weakening U.S. economy is setting the stage for lower interest rates. This was according to a UCLA Anderson Forecast. The forecast predicts real gross domestic product will rise no more than 2.7 percent next year, reflecting the weak housing market. As a result, the prediction is that the Federal Reserve Board will cut interest rates to stimulate business, says Edward Leamer, director of the UCLA Anderson Forecast. Leamer says he sees the Federal Funds rate falling to 4.5 percent by the fourth quarter of next year. Leamer also thinks housing starts will bottom out at an annual rate of 1.4 million in the second quarter of next year. As builders seek to sell inventory, new-home prices will fall to a low in the third quarter of 2007, down 10 percent from current levels, he says.

So if you believe what this report says you would think that now is the time to refinance and pull out the equity in your home because the value of your home is falling and you could loose your equity. The refinance would allow you to utilize your equity to do other things like home improvement or debt consolidation or even investment. Now if you are in the market for a new home, you may want to wait until September of this year to purchase so that you don't over pay for that home.

The dilemma all of us face is that for every opinion there is a counter opinion. The only way to really know what direction you should go is to ask a local expert in mortgage lending or real estate. Take the information they give you and make the best decision for yourself. Rates will rise and fall whether or not you buy or refinance. The only time you really care about Mr. Bernanke or what is going on in the market is when you are looking to purchase or refinance. So, although he may be the most powerful man in the world, you probably don't even care. The moral of the story is to find yourself local experts in whatever field you need information and not worry about the stuff or the people you can't control.