The Federal Reserve System:
There is much confusion regarding the Federal Reserve System. The Federal Reserve System is essentially a private corporation. The President appoints and the Senate confirms 7 governors, each for a long, 14 year term. Congress, although not having any direct influence on the Fed, looks over its shoulder and at times requests the Chairman’s presence to answer questions pertaining to the Fed’s actions.
The Fed is made up of 12 Federal Reserve Banks that issue shares of stock to ‘member banks’. The stock cannot be sold or traded. Although the Fed is not set up to generate profit, it does produce dividends that are set by law at 6 % per year. This is rather confusing as most of us assume that dividends represent corporate profitability. Go figure? The Fed also generates income from interest on Treasury debt that it buys and sells, interest paid on foreign debt it holds, interest from money it lends to your bank, (known as the ‘discount rate’), and foreign currency trades.
The Fed’s main objective today is to control inflation. It does this by managing the supply of money. Selling bonds takes cash out of the system, buying bonds puts more money back into the system. When necessary the Fed will buy dollars to support its value and sell dollars to cool things off. If, after all this buying and selling there’s money left over, it is deposited in the U.S. Treasury.
Even though the Fed was set up by Congress, the Federal Reserve is not a Government agency. It has been given extraordinary independence for good reason. First and foremost is the fact that the ‘governors’ have their finger on the pulse of the economy and can react instantly to financial events in times of crisis. When looking at the record that the Congress and the White House have in managing Federal budgets, we can all be thankful that the Fed is in control.
The Federal Reserve sets short term interest rates. These are the rates that banks are charged when borrowing money from the Fed or each other. On June 30, 2005, the Fed raised the short term interest rate for the ninth time in a year to 3.25%. This in turn raised the prime rate for business and consumer loans to 6.25%. It is expected that the short term interest rate will continue to move a quarter percentage upward at their upcoming August 9, 2005 meeting (Editor's note: Fed Hikes Rate after Hurricane Katrina). In fact, over the past year the short term interest rate has been raised from a 46 year low of 1% to today’s rate of 3.25%. Many experts believe that the ‘neutral level’ is at least 4% which means increases in the short term rate is expected to continue into 2006.
The Fed and Credit Card Interest Rates:
Many of you may be wondering if the bank’s discount rate is 3.25% setting the prime rate at 6.25%, why are we paying such exorbitant interest rates on our credit card bills? The answer is essentially, because the banks and credit card companies can! Their excuse is that credit card debt is unsecured, meaning that the lender has no collateral to collect should the debt go into default. To protect themselves, the banks and credit card companies charge interest rates that many consider to be usury. There is little that we can do as citizens other than contacting your Congressperson and expressing your contempt for the obscene rates charged on credit card purchases.
The Fed and Mortgage Rates:
As short term interest rates have steadily increased, mortgage rates have surprisingly done just the opposite, falling to their lowest level in more than a year. Add to these historically low mortgage interest rates the new phenomenon of no down payment or interest only mortgages and you have what is considered to be a real estate boom.
A full 22% of the economy’s growth in the last quarter was directly attributed to housing. This is beginning to be a concern to the Fed as some real estate markets are reaching the point of unsustainability. Should oil prices decline as they have been this week, the Fed may have to raise rates more aggressively to achieve its goal in controlling inflation by slowing the economy’s growth to between 3 and 3.5%. The problem is the Fed’s short term interest rate increases have little direct influence on today’s mortgage rates. It will take a series of increases over time for the Fed to have any appreciable effect on mortgage rates and sadly it will affect those homeowners that fell prey to the one year ‘teaser’ mortgages so popular today.
Mortgage rates are controlled by the global bond market not the Fed. The bond market dictates long term interest rates just the way stock markets arrive at stock prices, by a high or low bid. The Treasury sells bonds every 3 months. The more demand for a Treasury bond the higher the price. Recently, bond investors were reassured by the Fed’s tough stance on inflation resulting in higher bids. Higher bids means the Treasury pays less interest to sell them. Because the global bond market is so huge, other long term interest rates, like mortgages, follow suit.
Most economists believe that the strong demand for U.S. Treasury bonds resides with our $650 Billion trade deficit, the largest being with China and Saudi Arabia.
China alone has close to $225 Billion in U.S Treasury Securities. Obviously they believe one of the safest places to put excess cash is in U.S. Treasury Securities. To maintain the value of their investment, China has purposely kept their dollar low, pegging it to the U.S. dollar. This ensures that a weakening U.S. dollar will not affect Chinese holdings in U.S. Treasury bonds. The fact remains that if there was a sharp drop in the value of our dollar, foreigners would stop buying the paper we use to fund our federal spending and long term interest rates (ie: mortgage rates) would increase rapidly, no doubt creating a spate of foreclosures, repossessions and bankruptcies. It’s a delicate balancing act with major repercussions should we make the wrong decisions along the way.