Bankers Perspective On The Economy

Air Date: July 9th, 2020

Homebuyers often misunderstand how the Federal Reserve affects traditional mortgage rates. Here is the reality: the Federal Reserve does not set mortgage rates. Instead, it determines the federal funds rate, which in turn impacts shorter-term and variable interest rates. When the federal funds rate is cut, it becomes less expensive for banks to borrow, and in theory, those “savings” can be passed on to consumers in the form of lower interest rates on lines of credit – including mortgages. In other words, the Federal Reserve’s efforts to ease interest rates can, and usually do, pump up housing purchases since more people can afford mortgages. Lower rates can spur activity because some buyers can afford to upgrade (purchase a more expensive home or live in a more expensive neighborhood.

On March 15, 2020, the Fed announced it had reduced the reserve requirement ratio to zero effective March 26, 2020. It did so to encourage banks to lend out all of their funds during the COVID-19 pandemic.

Before that announcement, banks with more than $1.216 billion in net transaction accounts had to hold 10% of deposits in reserve. They could hold them either in their banks’ vaults or at the local Federal Reserve bank.

How does QE work and is it a good thing?

Keeping bond yields low by the federal government auctioning off large quantities of treasuries to pay for expansionary fiscal policy. As the Fed buys treasuries, it increases demand, therefore keeping Treasury yields low. Since treasuries are the basis for all long-term interest rates, QE also keeps auto, furniture, and other consumer debt rates affordable. The same is true for corporate bonds, making it cheaper for businesses to expand. Most importantly, it keeps long-term fixed-rate mortgage rates low, thus record real estate transactions and a VERY lively market.

  • QE attracts foreign investment and increases exports.
  • Increasing the money supply also keeps the value of the country’s currency low. This makes the country’s stocks more attractive to foreign investors and makes exports less expensive.

The downside – QE could lead to inflation

Ex: pre-2008 crisis, the Fed’s balance sheet held less than $1 trillion. By July 2014, that number had increased to $4.5 trillion. The more dollars the Fed creates, the less valuable existing dollars are. Over time, this lowers the value of all dollars, which then buys less. The result is inflation.

Inflation doesn’t occur until the economy is thriving. Once that happens, the assets on the Fed’s books increase as well. The Fed would have no problem selling them. Selling assets would reduce the money supply and cool off any inflation.

The most recent use of QE was in response to the COVID-19 pandemic. On March 15, 2020, the Federal Reserve announced it would purchase $500 billion in U.S. Treasury Bonds. It would also buy $200 billion in mortgage-backed securities over the next several months.

Should consumers expect rates to stay low for the rest of this year?

What happens when the Fed stops cutting rates or stops buying bonds? During 2019, the Fed was busy taking steps to prolong what has been the longest economic expansion in history.

Back in 2008, the average 30- year mortgage rate was more than 6%. Yet, whether you call it Quantitative Easing or not, the Fed’s decisions in 2019 have kept the economy humming and held down long-term interest rates while supporting stock markets in the U.S. and other parts of the world.
Before COVID, the Fed was set on ending its bond-buying strategy in the second quarter of 2020.

That plan is essentially gone due to a global pandemic that shut-down many parts of our economy. We have seen this movie a few times since 2008, sans the virus. But things will eventually return to normal. Interest rates near historical lows can’t stay down forever, right?

What will it take for mortgage rates to start trending up?

Over the past 50 years, rates on the 30-year fixed-rate mortgage have ranged from as high as 18.63% in 1981 to as low as 3.31% in 2012. Right now, consumers are enjoying some of the lowest rates on record. The byproduct is record realtor sales, refinancing, and consumer goods.
But, consider why a prospective homebuyer pauses when rates jump. A homeowner shopping for a $500,000 house and making a 20% down payment purchased a home with a 3.50% rate and a $2,317 monthly payment, including property taxes. Now, with a 4.42% mortgage rate, the same house costs 7.6% more on a monthly payment basis, or an additional $176.

If rates go up – rising rates curtail some home purchasing and refinancing. Additionally, home prices are rising, this could also add concern among prospective buyers. Housing affordability hinges on income and mortgage rates. Most buyers finance their purchase and shop for a house based on how much they can afford each month.

For our listeners entering the housing market, ask yourself what will happen when mortgage rates rise. Equally as important is the positive lesson we learned out of the Great Recession: Your residence should not be considered an investment. It’s a roof over your head, a place to welcome friends and family. It’s an expression of your personality and likely the largest purchase you will ever make. It is much more than an investment.