The Federal Reserve Open Market Committee decided today to hold steady the key short-term interest rates it directly controls. The Federal Funds target rate remained at a flat 2%, while the "discount window" rate -- the price for money the Fed lends directly to banks -- remained at 2.25%

The Fed's overnight target rate for the cost of interbank lending of reserves is just that: a target. The actual cost of the money fluctuates both above and below that number as demands for those funds between banks waxes and wanes.

Banks unable (or unwilling) to borrow in open markets can instead borrow directly from the Fed, via the "Discount Window" at the 2.25% rate. "Discount Window" borrowing is said to carry a stigma, because a bank which approaches the Fed for funds is thought to do so only as a last resort, after all attempts to borrow money in open markets have been rebuffed. The public nature of borrowing from the Fed -- and the ensuing questions about asset strength or even solvency -- may keep banks from getting to the funds that they may desperately (or not so desperately) need to cover reserve requirements. The Fed's new Term Auction Facility (TAF) allows much of the same function of the Discount Window, but on an anonymous basis, and has been instrumental in restoring liquidity to lending markets. Notably, LIBOR rates have declined sharply, as the Fed's offerings of cash has served to temper demand for funds traded in US dollars on the London Exchange.

The Fed's lack of movement today was widely anticipated. Growth has been hanging on by its fingernails, necessitating a low-rate stance in hopes of bolstering slow growth. Although inflation concerns have moved to the forefront of economic discussions, there was little chance that the Fed would increase rates at this time.

Actually, the Fed had kinder words for the economy than might have been expected, given all the headwinds and challenges faced by the US. The release at the end of the meeting said that "Recent information indicates that overall economic activity continues to expand, partly reflecting some firming in household spending." Even with that boost, dark clouds remain. The Fed went on to note that labor markets have softened further, financial markets remain under considerable stress, and that the housing market contraction, accompanied by tight credit conditions and rising energy prices will put the damper on growth over the next few quarters.

Perhaps more important was what the Fed had to say about inflation. A flat statement of "The Committee expects inflation to moderate later this year and next year" may or may not come true, especially in light of "continued increases in the prices of energy and some other commodities and the elevated state of some indicators of inflation expectations". However, that the Fed collective believes that prices increase will wane is important to soothe a market quite uncomfortable about inflation readings.

It's important to realize that those inflation readings are only a measurement of the rate of change in prices, not necessarily the price levels themselves. If prices stop increasing, it does mean inflation isn't worsening, but there might still be a high price left in its wake. For example, the high oil prices which are sapping economic strength will continue to do so whether the price is $3.80 per gallon of gasoline or $4.20 per gallon (and a drop from $4.20 to $3.80 would be almost a 10% decline in price).

Mortgage interest rates have already firmed in recent weeks, and will likely remain on a firmer path, as the Fed keeps short-term interest rates low while inflation concerns remain high. Mortgage borrowers need to be aware that one of the tonics for a weak economy is lower short-term interest rates, and if the Fed continues to oblige by keeping them low, a growing economy becomes that much more likely to occur. That growing economy -- especially at a time of firm or rising inflation pressure -- will tend to press long-term interest rates upward.

In addition to inflation concerns serving to keep longer interest rates firm, perhaps more important is that mortgages remain out of favor among investors. In order to attract investors to buy mortgages, higher yields -- reflected in higher rates -- are required, relative to other fixed-income investments. The ability to make new, better-quality loans at higher yields (or spreads over incoming costs of obtaining funds) are the ingredients for profitable lending, and restoring balance to troubled loan books. Together, these represent keys to lender's willingness to keep lending, instead of simply holding onto more cash in troubled times.

Click here for an up-to-date graph and table of the Federal Funds rate.

Lower overnight and short-term rates, coupled with the Fed's Term Auction Facility (TAF), have served to press common ARM indexes back down. LIBOR especially has benefited from the Fed's anonymous auction of fresh cash to lend. Treasury values are holding at multi-year lows, and LIBOR rates have moved closer to their normal relationship with other interest rates.

For Jumbo (aka "non-conforming") borrowers, fixed rate mortgage interest rates remain rather high. Temporary changes to Conforming loan and FHA limits may allow some borrowers access to new mortgage funds at lower rates, but those programs are just getting underway. If nothing else, Jumbo borrowers could consider new ARMs as a quasi-temporary product if a fixed-rate is too pricey for their budget.

Holders of ARMs tied to the COSI, COFI, or other deposit-based indices are finally seeing rates decline after a period of spirited competition for deposits served to keep rates high. The Fed's moves, coupled with the TAF and expansion of the TSLF to include auto loan and credit card securities are serving to lessen the demand for deposits, meaning banks can pay lower rates for those funds (and in turn, hopefully lower rates for loans, too). The MTA has finally begun to reflect lower interest rates for one-year Treasuries and has been stepping downward more noticeably this year, helping borrowers whose short-term (often PayOption) ARMs become somewhat more affordable.

Holders of short-term PayOption ARMs should know that the true ("fully-indexed") rate of interest on an MTA-based ARM has finally fallen back in line with LIBOR-based ones. Despite that fall in rates, borrowers making a "minimum payment" as though the interest rate is just 1% or 2% need to be aware that they are accruing negative amortization at a rapid pace. Borrowers with minimum-payment Option ARMs are becoming delinquent at a more rapid pace, as rising mortgage balances and falling home prices make "ownership" less compelling. Also, those making interest-only payments may continue see their costs go up and up even as their loan balance remains steady. Some are likely refinancing to more fixed-rate products.

Click here for a graphic demonstration of the relationship between the Fed Funds and mortgages.

As the Prime Rate is heavily influenced by any move in the Federal Funds target rate, no change is likely to occur right now. As a market interest rate, there have been periods when the Prime has moved well in advance (or well after) any Fed move, but the relationship between Fed Funds and Prime has strengthened considerably over time.

Contrary to popular belief, the Fed has no control over the Prime Rate or any other market-based interest rates, but the Fed's observations about market conditions and changes to monetary policy do influence the overall cost of money. The decline in the Prime over the past few months has no doubt brought relief to borrowers with Home Equity Lines of Credit (HELOCs), who watched their interest rates more than double during the Fed's 2004-2006 cycle of increases. Over that time, the Prime Rate jumped from 4% to 8.25%, mirroring the 425 basis point increase in the Fed Funds rate. The present 5% prime rate may be especially helpful to those whose HELOCs are part of a "piggybacked" mortgage origination, as that doubling in interest rate on a line taken in lieu of a down payment likely caused some borrowers a fiscal headache. See the latest averages for HELOCs here.

Good credit quality 'conforming' borrowers now shopping for variable-rate products tied to short-term indicators will generally find credit conditions to be improving at the moment. Lenders are aggressively seeking new business from solid borrowers with strong equity positions, so rates and fees may actually be improving for certain equity seekers. Borrowers with non-conforming credit needs will probably continue to find a challenging credit environment, and should be prepared to shop aggressively to find a suitable loan.

Want to see today's ARM indexes? Click here.

Watch the HSH Market Trends each Friday for our latest take on market activity, forecasts and more. Sign up for a subscription today!

Comments

Got something more to say about this topic? Feel free to submit your comments. (All comments are reviewed before posting.)

Thanks for your input - watch this space for the results.