Interest Rates: Is the Fed Changing Its Tune?

It appears that, while not backtracking, the Federal Reserve has indeed changed its tune regarding their policy on interest rates. The Federal Open Market Committee, or FOMC, wrapped up its most recent two-day meetings this past January 30. The FOMC meets about every six weeks to review the current state of the economy, review recent past and with that information make predictions into the future. One of the key responsibilities of the Fed is to control the cost of money. That includes the cost of money for consumers as well as the cost of money for banks and other depository institutions.

Interest Rates vs. Mortgage Rates

Briefly, the Fed controls the cost of funds for banks who then adjust the interest rates they charge consumers ranging from credit cards to automobile loans and is tied to an individual bank’s reserves. Banks are required to have a specific amount of accessible capital, that is, funds readily available to its customers upon demand. Reserve requirements are based upon several variables, but the primary factor compares how many outstanding loans there are to cash reserves.

Before banks were universally regulated, a “bank run” was not an uncommon event. Merely a rumor that a bank was in trouble could cause their customers to rush to the bank and withdraw all their money before the bank officially closed up shop. Today, not only are banks required to keep a specific amount of cash on hand, but depositors’ funds are insured in the instance of a loss.

When a bank sees that it will be short of cash reserves at the end of the day, the bank will borrow funds either from another bank or directly from the Federal Reserve. These short term loans are used to shore up the required reserve accounts to meet federal requirements. When the Fed raises or lowers interest rates, this is the rate that is adjusted.

How it Works

The Fed doesn’t directly impact mortgage rates but there is an ancillary effect. Adjustable-rate loans based upon the WSJ Prime rate follow Fed moves almost in lockstep, but your traditional 30-year fixed rate conforming does not. Instead, mortgage companies anticipate Fed moves and not react to them. Rarely will the Fed make an announcement or raise or lower a rate that surprises mortgage companies. This is why mortgage rates rarely budge after a Fed announcement. How so?

Mortgage companies hire full-time staff that monitors the very same data the Federal Reserve looks at. As each bit of economic data is released from various government agencies and bureaus, that data can provide guidance on what the Fed will or won’t do at the next round of FOMC meetings. If several reports indicate the economy is slowing down that can indicate the Fed might indeed lower the cost of funds and if recent economic reports show the economy is running on all cylinders that will tell mortgage companies that higher rates are ahead.

At the end of each FOMC meeting, the Fed Chair issues a short statement, typically only about 300 to 350 words. It is these words that provide some degree of insight on where the Fed might be headed. This direction appears to have changed since last fall.

The Fed decided to stand pat on January 30 and left the Federal Funds rate alone. This was not surprising, so interest rates remained relatively stable with some signs of improvement. Yet it was the statement that supplied more information. Back on October 3, Fed Chair Powell stated that the Fed was “a long way” from adopting a neutral stance on rates. A neutral stance means rates are currently in the Goldilocks stage- not too high, not too low. This October 3 message signaled the Fed wasn’t through with raising rates. This of course spooked investors as many blamed that Fed statement on the losses that began to hit the Dow. Just a couple of months later in December, Powell said the Fed would be on “autopilot” and would not commit to a timeframe for any new rate increases. Earlier in the year, Powell was pretty firm when he said we would see two more rate increases in 2019. Now he’s not so sure.

The latest statement at the conclusion of the most recent FOMC meetings read, “…the Committee will be patient as it determines what future adjustments to the target range for the federal funds rate may be appropriate…”  The committee also changed verbiage on expected economic growth from “strong” to “solid.” For Fed watchers, that means something. It says the economy is not currently viewed as being as strong as it once was and dropped the strength of the economy down a notch.

Okay, let’s quickly review these declarations on the economy. At the first of the year, Powell declared there will be two more rate increases in 2019. Later in October, those two increases were affirmed but then in December, the tone softened. The Fed would be on autopilot with a hands-off policy until more economic data is reviewed. Finally, the most recent statement indicated a softer approach from the December statement.

What’s Next

What does that tell us? It tells us, at least over the next few months, that the economy will be solid but not strong enough to warrant another rate increase. This could very well mean heading into the third quarter of 2019. What the Fed is far from saying is the economy is faltering and lowering rates is on the radar. It’s not on the radar.