Thursday, 20 November 2008
Those stubborn US mortgage rates
Here is a wonderful chart that illustrates the impotence of central banks today. It tracks the spread between the 30 year US mortgage rate and the federal funds rate. In more simple terms; the spread is the difference between the two interest rates.
The mortgage rate is determined by market forces, such as the supply and demand for credit, and more generally the willingness of banks to take on more risk. The federal funds rate is the policy instrument of the US central bank. By changing the federal funds rate, the Fed hopes to manage all interest rates, including the 30 year mortgage rate, and ultimately the whole US economy.
With the collapse of the US housing market and the onset of the credit crisis, the Fed cut rates, but mortgage rates remained stubbornly high. This means that the spread goes up.
This breakdown in the relationship between mortgage and policy rates, probably goes a long way to explain a paragraph in the minutes of the most recent Fed meeting on interest rates:
"Some members were concerned that the effectiveness of cuts in the target federal funds rate may have been diminished by the financial dislocations, suggesting that further policy action might have limited efficacy in promoting a recovery in economic growth. And some also noted that the Committee had limited room to lower its federal funds rate target further and should therefore consider moving slowly.
However, others maintained that the possibility of reduced policy effectiveness and the limited scope for reducing the target further were reasons for a more aggressive policy adjustment; an easing of policy should contribute to a beneficial reduction in some borrowing costs, even if a given rate reduction currently would elicit a smaller effect than in more typical circumstances, and more aggressive easing should reduce the odds of a deflationary outcome."
In other words, half the fed policy committee think changes in rates are useless, while the other half think rate cuts might work if they are large enough. Unfortunately for the Fed, rates are now at just 1 percent. They can't go lower than zero, so the Fed might have lost total control over monetary policy.
However, when I look at the chart above, I wonder whether the Fed ever really controlled mortgage rates. During the bubble years, the spread went down to one percent. Even though the Fed tried to stem the housing bubble, banks wouldn't play along. They kept rates low despite the policy actions of the Fed.
The chart also points to a more difficult question; how will the US market recover with mortgage rates remaining so high. The answer, of course, is that it won't.