It’s election season, and that means endless robocalls, yard signs on every corner, and, most of all, endless rhetoric on every topic – from the economy to golf handicaps. This season, interest rates seem to have captured center stage.
Interest rates may very well warrant the spotlight. After all, interest rates affect most of us every day, whether we’re trying to buy a car, run a business, or look for a job. But who sets these rates? The President? Congress? The teller at the local branch? The answer is both endlessly complicated and boringly simple.
Election season is filled with politicians’ promises of “lower interest rates” and thus, a “stronger economy.” The means by which these statesmen seek to keep these covenants is through the Federal Reserve. Anyone who watches CNN or Fox News has seen an army of news correspondents clammer in eager anticipation—like children on Groundhog Day—for the Federal Reserve’s announcement as to whether interest rates will be cut or whether we will have six more weeks of economic winter. But why?
It is a commonly held belief, perpetuated by politicians, that the Federal Reserve controls interest rates. However, as is with most things, the truth is more complicated.
The Federal Reserve has one main recourse by which to influence interest rates, and that is through the Federal Funds Rate, which the Federal Reserve, through its Federal Open Market Committee, sets [generally] every six weeks. The Federal Funds Rate is the overnight rate at which financial institutions lend money to one another and, more simply, determines the amount of money available in our economy (with a higher Federal Funds Rate constricting money supply and a lower rate increasing money supply).
On September 18, 2024, the Federal Reserve cut the Federal Funds Rate by 50 basis points, signaling a desire by the Federal Reserve to increase the supply of money into the American economy. Why then, two months later, are many of us left wondering why the rates to buy a house or a used Ford Focus have not gone down?
The truth is that although the Federal Funds Rate does influence the rates at which you can borrow money to buy a house, it is but one factor in an increasingly complicated equation by which each bank, individually, determines the rate at which it will lend money.
In the case of home loans, there are many factors that determine the rate at which banks will lend money to borrowers to buy homes: default rates (risk), long-term treasury rates (alternative investment), and market conditions, none of which are determined by the Federal Reserve or any other faction of our government.
When the Federal Reserve cut the Federal Funds Rate in September, the yield of long-term U.S. Treasury Notes (the amount that investors are willing to pay for treasury notes, which is set by the market at auction), did not go down; in fact, it went up. These treasury yields are important because mortgage-backed securities and long-term treasury notes compete for the same investors, and if investors are more interested in buying treasury notes than mortgage-backed securities, then banks will be less willing to make mortgage loans to borrowers to buy homes and, in turn, mortgage interest rates go up.
Interest rates, and how they’re made, has been hotly debated on morning shows and countless pages of scholarly articles, but the complex truth is simple: the market dictates interest rates and “nobody, I don’t care if you’re Warren Buffet or Jimmy Buffet, nobody knows if the market is going to go up, down, sideways or in circles.”
It is reproduced with permission from the publisher. Originally Published in The Journal Record - November 7, 2024
