Realities of Real Estate: Why you should care about the Fed funds rate

Our guess would be that 99 out of 100 people don’t have any idea what the Fed funds rate is, even though it’s something that directly affects the economic well-being of 99 out of 100 people, maybe even 100 out of 100.

So, what is the Fed funds rate, and why should you care about it? In short, it’s an economic benchmark that, along with free market forces, determines interest rates on everything from cars to homes; and in a credit driven world, changes in interest rates not only affect those with debt, they can influence the entire world economy. As a result, the funds rate is a key measure, and after nearly seven years of being essentially 0 percent, the funds rate is about to start going up!  Here’s how it all works.

First, let’s start with a review of the Federal Reserve, since it is the body that controls the Fed funds rate. The Federal Reserve System was created by Congress in 1913 in response to the banking meltdown that began in 1907. In the early part of the 20th century, the stock market was collapsing, resulting in a run on the banks. Our entire financial system was in turmoil, driving us toward the Great Depression. Consequently, the Federal Reserve System was created to act as sort of a backstop for the banks.

If an economy is to weather tough financial times, it is necessary to maintain liquidity in the system.  In other words, there must always be enough cash on hand to avoid panic and grease the wheels of our economic engine. When liquidity was insufficient to keep things moving, the Fed could step in and generate the cash necessary to help restore equilibrium in the supply and demand of money.

The Fed has a number of ways to do this, and the economics of it can be fairly complex. But, in simplest terms, think of the Fed as a pressure relief valve. Largely through the management of interest rates (with the Fed Funds rate), the Fed can pump cash into the system to bolster economic growth. But, when the economy gets overheated, it can also blow off steam by reducing the money supply.

It’s a delicate balancing act. Too little money and the economy will stall. Too much money and the excess cash will result in inflation, an equally burdensome problem for our financial well-being. The Fed meets eight times a year, with 12 people who, among other things, decide if interest rates (by way of the Fed funds rate) will stay the same, go up or go down. The next Fed meeting is mid-December, and most economists now believe that, a week before Christmas, the Fed is going to leave a lump of coal in your stocking with a rate increase of one-quarter point.

As we said, market forces also have a bearing on the extent to which changes in the funds rate can impact other interest rates. If the economy is a little soft, changes in the funds rate might not entirely flow through to the consumer.  hat’s the situation we might have now.

When the stock market crashed in 2008, and the economy went into the tank, the Federal Reserve dropped the Fed funds rate to nearly zero. Rates on a 30-year fixed rate mortgage had been around 6 percent from 2002 to 2008. When the Fed dropped their rates, mortgage interest followed suit and fell to a new level of approximately 4 percent, where they’ve stayed for about five years now. Plus, even though mortgage rates are historically low at 4 percent, the banks have been making out like bandits, because the spread between the funds rate and mortgage rates is very large. If you can borrow money from the Fed at .12 percent and loan it out at 4.0 percent, it’s not hard to make money.

But, since the economy is still weak, it will be difficult for financial institutions to pass along any or all of the anticipated increases approved by the Fed. Consequently, the banks will most likely need to absorb some of the Fed increase by taking a bit of a hit on the ample profit margins associated with mortgage lending. This is why we haven’t seen mortgage rates move much, even though a funds rate increase is widely expected.

Nevertheless, if the Fed rate change takes place in December, it will be only the first of what is believed to be a series of increases. Over time, this activity by the Federal Reserve will ultimately push up mortgage rates. How high they will go is dependent on the degree to which the overall economy strengthens.

So, if you want one of those 4 percent or slightly under 4 percent mortgage rates, now is probably the time to act. Like $1.95 gas, those rates aren’t likely to be around for long.