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Can ‘they’ really afford to let that happen?

July 7, 2017
By BOB and GERI QUINN - Homing In , Cape Coral Daily Breeze

Back in the first week of April, we discussed the fact the Federal Reserve finally seemed committed to following through on a new course of economic action by actually raising short-term interest rates, instead of just talking about it. At that time, we noted that in December 2016, The Fed tweaked interest rates by a quarter-of-one-point, or 0.25 percent, for the second time in a year, after going through one of the longest periods in Fed history without raising interest rates following the mortgage-backed financial crisis. This was followed by another quarter-point rate increase in March of this year, as they verbally reinforced their policy shift towards a rising interest rate environment by indicating several more rate hikes would likely be on the way later this year. This stoked growing concerns that we could be heading for a slowdown in the housing market due to what would seem to be an inevitable, continued rise in mortgage interest rates.

Then, following their mid-June Federal Open Market Committee meeting, they raised interest rates by another 0.25 percent, while indicating their plans for another rate hike if economic conditions stayed favorable enough to warrant such a move. So this week, we thought we would take a look at The Fed's progress, along with the impact their interest rate moves are having on mortgage rates and the housing market so far in 2017.

One of the things we pointed out in April, was that the Janet Yellen-led Federal Reserve is increasing the interest rate on the Federal Funds Rate, which is an ultra-short-term interest rate over which The Fed has complete control. The Fed Funds Rate is the overnight lending rate between financial institutions, which applies to banks and credit unions when they need to make overnight loans to each other in order to maintain their reserve requirements as set by the Federal Reserve. It is important to note The Fed has no direct control over setting the interest rates on mortgage loans, which are "market-based" interest rates that are impacted more by market factors, such as the supply and demand for mortgage loans.

During the mortgage-backed financial crisis, the then Ben Bernanke-led Federal Reserve implemented extreme emergency measures to try to prevent a complete meltdown of the financial system by making drastic reductions to the Federal Funds Rate, quickly slashing it from a pre-crisis level of 5.25 percent, down to zero percent by December 2008. When Janet Yellen replaced Bernanke as Fed Chairman, she maintained this zero interest rate policy, known as ZIRP, for an extended period of time, even though the financial crisis had supposedly ended. The Fed's ZIRP is why interest rates on bank certificates of deposit and savings accounts all but disappeared over the last 10 years.

With the 0.25 rate increase in June, the Fed Funds Rate is now up from near zero percent to a range between 1.00 to 1.25 percent, and all indications are that The Fed would like to eventually ease this interest rate up towards 2.00 percent. Keep in mind this rate was at 5.25 percent back in the "normal" times prior to the financial crisis, so a return to anything close to the old normal anytime soon, would likely be a painful journey back in time for our economy.

This brings us to our headline question, "Can 'they' really afford to let that happen?" The "they" we are talking about is Janet Yellen and The Fed, along with our government in Washington. Here is just one of many different schools of thought on this topic.

When The Fed starts raising the short-term Fed Funds Rate, it can easily cause a "shock" to the system and result in a severe economic slowdown, or recession, because when the Fed shifts to a rising interest rate policy, it sets the "tone" for potentially higher interest rates throughout the financial system. This means money gets more expensive for everyone to borrow and if borrowing gets more expensive, the flow of money through the economy usually starts slowing down. This is one of the reasons The Fed is trying to be cautious in how they go about raising interest rates, because if they move rates up too much, too fast, the economy can stall out. Can "they" afford to let that happen? Let's look at some potential issues that may provide some insight into this question.

Over the last 10 years, with ZIRP firmly in place, the federal government was able to afford to go on what many would consider to be a wild spending spree, almost doubling its debt. If interest rates start returning to anywhere near the "old normal," the repayment costs on that debt would likely spiral out of control. The situation is similar for consumer debt, which is said to be at or above the pre-crisis levels. And to top it all off, during the financial crisis, The Fed accumulated some $4.5 trillion of "troubled" interest rate sensitive mortgage-backed securities and treasuries onto their balance sheet, which is one of the ways they were able to engineer the bailout of the financial system, while pumping newly created cash into the economy and the markets. They plan to start unloading these assets later this year, but as interest rates go up, the price and value of these holdings goes down. Can "they" afford to let that happen?

Let's look at the housing market and mortgage interest rates. According to mortgage buyer Freddie Mac, the interest rates on a 30-year fixed rate mortgage averaged 3.65 percent for the year in 2016, which was the lowest level in records kept dating back to 1971. Just before The Fed raised interest rates back in March, the yield on the 30-year fixed rate mortgage had climbed to 4.30 percent, or 17.81 percent higher than the average for all of last year. And despite The Fed's recent rate increase in June, the yield on the 30-year fixed rate mortgage for the week ending June 29 was at 3.88 percent. This is down by 9.77 percent from back in March of this year, so what we may be seeing at this point could be a "market-based" concern about the impact of rising short-term interest rates slowing down the economy.

It's still too early to tell for sure if The Fed's interest rate moves are having a negative impact on the economy, but we are also seeing some flattening of yields in the U.S. Treasury market, where the spreads between shorter maturity and longer maturity treasuries are tightening. We have seen the yields on shorter-term treasuries increasing proportionately to The Fed's rate increases, but once you get out to about a 3-year maturity and beyond, the yields are flat to lower. This is something we'll be watching, for clues about the economy and the mortgage market, as we try to determine if "they" will try to contain interest rates.

(The information for this article is based in part on opinions expressed by Bob and Geri Quinn as of July 4, 2017, and the data was obtained from outside sources, including Freddie Mac and the Federal Reserve Economic Data (FRED) reports provided by the Federal Reserve Bank of St. Louis. The data and statistics are believed to be reliable, however, they could be updated and revised periodically, and are subject to change without notice. The Quinns are a husband and wife real estate team with Century 21 Birchwood Realty Inc., in Cape Coral. They have lived in Cape Coral for over 37 years. Geri has been a full-time Realtor since 2005, and Bob, who also holds a Certified Financial Planner designation, joined with Geri as a full-time Realtor in 2014. Their real estate practice is mainly focused on Cape Coral residential property and vacant lots.)



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