Interest Rates and Monetary Policy

Today is a big day for interest rates and therefore Treasuries and therefore mortgage-related securities and therefore mortgage rates. Today the Federal Reserve will hold its latest monetary policy meeting. These meetings are held about every six weeks (but the Fed can call unscheduled meetings as it did three times in 2001).

The Federal Reserve is charged with the responsibility to see that the U.S. economy maintains a relatively stable course. When the economy speeds up (high production, high consumption, high employment) it eventually ignites inflation which dilutes the value of money.

To slow down the economy, the Fed's monetary policy arm, the Federal Open Market Committee (FOMC) raises its target on a benchmark short-term borrowing rate. This is the federal funds rate, the interest rate charged by banks for overnight loans necessitated by Fed regulations that banks maintain a certain level of reserves each day. When the fed funds rate is changed, the banks will also change the rate they charge their customers to borrow. The prime rate is the rate banks charge their best business customers for loans. Interest rates, therefore, permeate the financial system as lenders seek to obtain borrowers.

To obtain its fed funds target, the Fed sells a portion of its Treasury holdings on the open market (hence the name Open Market Committee). Unlike sales by other traders, the money paid for these Treasury securities does not go into a regular bank but into the Federal Reserve account. This drains funds from the monetary system and the reduced supply is therefore more valuable and the fee for borrowing it goes up. This is what has been happening since June of 2004 when the Fed began hiking the rate by 0.25% increments at each of its policy meetings up through last June's meeting. In those seventeen hikes, the rate has gone from a forty-six year low of 1.00% to its current level of 5.25%.

It should be noted that some of the recent rate hikes are not seen by the Fed as specifically reining in the economy but simply as recalibrating the rate structure to a more normal level after the extreme cuts which preceded the current tightening cycle. Between January of 2001 and June of 2003, the Fed made thirteen cuts (nine 0.50% cuts and four, 0.25%) in order to stimulate a slumping economy. A cut is accomplished through the purchase of Treasuries, which adds money to the monetary system.

The way mortgages fit into all of this is that they represent money that is lent out to be paid back with interest. This debt can then be sold in the financial markets in the form of mortgage backed securities. An investor evaluates the levels of risk and reward to decide what the most profitable investment is. Treasuries are virtually risk free because they are issued by the government. Mortgages are more risky because borrowers can pay off their debt sooner than expected (depriving investors of interest income), or borrowers can stop making payments
altogether and default on their obligation. Obviously, investors will demand a higher return on a mortgage-backed security than on a Treasury security.

Since the price of a bond is determined by a bid and offer process, a number of factors are involved in evaluating the instrument. One factor is the coupon rate, that is, the fixed amount of interest that is paid on a regular basis to the owner of the security. But many investors are more concerned with the yield that the security offers. If one must pay more than the face value of the bond, the net effect is to reduce the original yield from what it would have been at par (paying only the face value). On the other hand, paying less than the face value will increase the yield since at the end of the maturity period, the whole face value will be received in addition to the interest payments previously received.

If interest rates go up, Treasury coupon rates will also go up (the government is borrowing from the investor). Current security issues will therefore decline in value. Who would pay full price for a bond that won't make interest payments as high as another bond with similar risk characteristics? So the threat of higher interest rates has a negative effect on the bond market.

At the last FOMC meeting on August 8, the committee decided not to raise its target for the fed funds rate, though the meeting statement noted that "some inflation risks remain." It went on to say, however, that "the extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information."

The economic situation since the August meeting can be summarized in the first sentence of the Fed's latest edition of is Beige Book, an anecdotal summary of economic conditions, "Reports from the twelve Federal Reserve Districts indicate that economic activity continued to expand since the last report, but five Districts indicated deceleration while the remaining seven reported little change in the pace of growth." This suggests that another rate hike could overcool the economy. Moreover, recent inflation data (the Consumer Price Index and the Producer Price Index) have been benign. Moreover, a recent sharp drop in oil prices has eased a major inflation concern for now. Consequently, most Fed watchers are not expecting a rate hike today but they will be eager to see if the policy statement contains any clues to upcoming Fed actions.