4th Quarter Home Interest Rates

As the business week ended last Friday (but not the week for real estate agents), analysts found things other than the housing market to discuss in the dragging U.S. economy. And they started looking ahead to the end of January for more relief from the Federal Reserve. Here is a primer on how the Federal Reserve works and why it matters for Flagstaff real estate.

The Federal Reserve is the central bank of the United States government and through its control over monetary policy is the guardian of the U.S. economy. The Fed is composed of 12 regional banks that individually gather data to report economic conditions and handle money transfers between banks (among other things). Our regional bank is located in San Francisco.

As a group, the heads of the twelve regional Fed banks and the Chairman, now Ben Bernanke, determine many economic policies. Among those policies is the determination of how much money and what terms are available to member banks (where you put your money) for borrowing directly from the central bank.

There are two ways that commercial banks (the ones we use) can borrow money using Federally-insured funds. They can borrow money directly from the Fed using the "discount" rate, or they can borrow from each other using the "federal funds" interest rate. Both are short-term or overnight rates. The discount rate is designed to improve liquidity for the banks themselves. The federal funds target interest rate is meant to impact consumer credit. Banks, like mortgage brokers, get their home loan funds elsewhere, however.

It comes as a surprise to many home buyers and sellers that one thing the Federal Reserve does not do is set home mortgage interest rates. Home loan lenders, including banks and brokers, set interest rates based upon their costs to gather money to make the loans. The lenders' costs are based on several factors, but primarily upon the yields from mortgage-backed securities. Mortgage-backed securities are traded on national exchanges, just like Microsoft and Apple stock or like corporate bonds.

When the bond yields go down on these trading markets, interest rates follow. Bond yields go down when the market believes inflation is under control. If that happens, mortgage interest rates will drop, and housing becomes more affordable. So, if bond investors believe inflation is a concern, home interest rates will go up. If they think inflation is under control, home loan rates will be steady or fall. So, in predicting where home loan rates will go in 2008, we need to look not just at the housing market, but the overall economy.

There was such bad news for the U.S. economy this past week that President Bush called a Friday afternoon meeting of his top economic advisers, including Vice President Dick Cheney, Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke. They are worried not just about a depressed housing sector (which, may, in fact, be in the process of turning around), but also about oil prices of $100 a barrel, a weakened dollar (see #8 in my 2008 Outlook), and -- as was announced Friday morning -- an up-tick in unemployment. A jobs report from the Department of Labor Friday showed a leap in the jobless rate to 5% from 4.7%, as well as the most-meager gain in new jobs in more than four years. Earlier in the week, a report on the manufacturing sector of the U.S. economy revealed the slowest activity seen since 2003.

With all the bad news about the economy, it would be easy to predict, and many analysts did on Friday, that the Federal Reserve will cut its interest rates to banks at the end of this month to try to improve the outlook by encouraging more borrowing. The problem for the Fed, however, is the rising price of oil and the weakness of the dollar abroad (primarily because of high deficit spending by the federal government). These two factors create a risk of inflation, which would be exacerbated by the further cutting on interest rates.

Regardless of what the Federal Reserve does, if bond and mortgage security investors believe the risk of inflation is rising, mortgage rates will rise. With oil at $100 a barrel, gas prices at over $3.00 per gallon, and a federal deficit apparently out-of-control, at least until the next election is over and the political environment settles down, who wouldn’t worry about inflation?

Take a look at the chart of home loan rates accompanying this post. The typical fixed rate of interest on a 30-year home loan in December was below earlier in the year and below 6.25%. This is incredibly low historically. Unfortunately, I’m old enough to remember when interest rates for homes were above 15%. Just a few years ago, rates below 8% were considered incredibly low. Since you are most likely buying a home for the long-term, I would not take the risk of waiting for interest rates to fall further, because I don’t think they will.