Back in 1971, comedian John Cleese, with the British sketch comedy show, Monty Python's Flying Circus, coined the phrase, "And now, for something completely different," which was followed by a fireball-type explosion, as the comedy troupe moved from one skit to another. So today, we thought we would shift gears and discuss something completely differ-ent.
As many of you are probably aware of by now, after mostly just talking about interest rates for the last several years, Janet Yellen and the Federal Reserve (The Fed) seem to finally be committed to something completely different, as they have changed course from maintaining record low interest rates to actually taking action, and raising rates. As The Fed changes course from one economic skit to another, we're pretty sure that this time they hope to avoid the fireball explosions associated with some of their past policies.
Looking back over the last 20 years, some might argue The Fed's monetary and interest rate policies, along with the timing of their changes in direction have, at times resembled a flying circus that only Monty Python would understand. During this time frame, The Fed has brought new meaning to some of the most feared words ever uttered on Wall Street, "This time it's different," as they have taken us through repeated periods of irrational booms, followed by even more painful busts. Each time, many hard-working folks thought everything was under control, as it unraveled right before their eyes because, "This time it's different!"
So now, as The Fed is trying to emerge from what may likely go down as one of the most manipulated economic periods in their history, we can only hope that they are getting it right this time. Here are some of the basics about what The Fed has been doing and what could happen with interest rates, along with how it could impact the housing market.
When you hear that The Fed is raising interest rates, it is involving the Federal Funds Rate, over which they have complete control. This is the ultra-short-term interest rate for overnight lending between depository institutions, which is how banks and credit unions loan each other money to keep their reserves at the appropriate levels, as required by The Fed.
When The Fed lowers this interest rate, it increases the supply of money in the economy by making it cheaper to borrow money, and when they raise this interest rate, it decreases, or tightens the supply of money, by making money more expensive. As an example, just before the housing market and mortgage-backed financial crisis hit about 10 years ago, the Fed Funds Rate was at 5.25 percent. As that financial crisis quickly spread, The Fed went into its "emergency mode," making aggressive cuts to this rate to pump extra money, or liquidity, into the banking system to keep it and the economy afloat, while trying to prevent the tidal wave of bad mortgage loans from swamping the entire financial system.
This brought the Fed Funds Rate down to nearly zero percent, where it remained, well after the financial emergency had supposedly ended. By leaving interest rates at near record lows for such an extended period of time, it is thought by some experts that The Fed likely created an artificially manipulated market scenario. These "cheap money" policies also enabled the federal government to go on a wild spending spree, financed by record levels of debt, while the average American on Main Street saw interest rates on their savings all but disappear.
To top it all off, The Fed initiated massive programs to buy back hundreds of billions of dollars worth of government debt, such as 10-year U.S. Treasury Notes, which are the benchmark for determining the interest rates on fixed-rate mortgage loans. These buybacks served to artificially lower mortgage interest rates, in essence, allowing the government to manipulate what are normally "market-based" interest rates.
That brings us back to today, where after one of the longest periods without raising interest rates in Federal Reserve history, the Janet Yellen-led Fed is back to tweaking the Federal Funds Rate once again. In reality, this is something that probably should have happened several years ago, but all the same, here are some of the dynamics that are likely to be in play over the next year or two, as interest rates are moved higher.
One of the potential scenarios, as the Fed Funds Rate is increased, is that, "This time it really is different," and despite all the manipulation of interest rates over the last 10 years, The Fed nails it this time and guides us back to normalization without any major incidents.
Another possibility, is that this is less about our economy starting to grow too fast and more about The Fed's need to get the Fed Funds Rate back to around the 2 percent level. That way, if there is another financial crisis, they will have some room to make emergency rate cuts as a bail-out measure, along the lines of what they did during the housing and mortgage-backed crisis 10 years ago. If interest rates are too low when another crisis happens, The Fed will be "boxed-in," with a limited ability to come to the rescue again.
Regarding the potential impact on the housing market from higher mortgage rates, the higher rates climb, the more likely it is to slow down the housing market and reduce the purchasing power of potential buyers. This could result in stagnant or declining home values because loan costs will be higher, meaning buyers will be able to afford to buy "less home" for their dollars. So one of the worst case scenarios would be that as the Fed Funds Rate is increased, the interest rates on mortgages continue to even higher levels and effectively stall-out the housing market.
Sometimes, as the Federal Funds Rate is increased, the higher short-term interest rates cause an economic slowdown or a recession, in which case we would likely see mortgage rates flatten out or even decline. We could see a similar downward move on mortgage rates depending upon the outcome of the upcoming European elections, along the lines of what we saw after the Brexit vote in Great Britain last summer.
Getting back to a normalized interest rate environment, if that's where we are headed, is likely to be an interesting process with some unexpected twists and turns, which for now, will not be something completely different.
(Information for this article is believed to be reliable and the opinions expressed are those of Bob and Geri Quinn, and they are subject to change without notice. The Quinn's are a husband and wife real estate team with Century 21 Birchwood Realty, Inc., in Cape Coral. They have lived in Cape Coral for over 37 years. Geri has been a full-time Realtor since 2005, and Bob, who also holds a Certified Financial Planner designation, joined with Geri as a full-time Realtor in 2014. Their real estate practice is mainly focused on Cape Coral residential property and vacant lots.)