If housing's down, why are interest rates up?

John W. Schoen • Profile • E-mail

The latest interest rate move by the Federal Reserve — a whole lot of nothing — has some readers, including Alvin in North Carolina, wondering why central bankers aren't doing more to help the ailing housing market by cutting rates. Hint: They're still worried about inflation. OK, asks Jeff in Sacramento, what exactly is inflation and what causes it?

If the housing market is in a slump, and it surely is, why is the Fed increasing the interest rates, which would make it even harder to qualify or get a loan mortgage?
—Alvin E., Belhaven, N.C.

In fact, the Federal Reserve’s latest move was to leave short-term interest rates just where they’ve been for the past 12 months. The Fed-controlled rate for banks borrowing money from each other remains at 5.25 percent. But that won’t help you if you’re trying to get a mortgage to buy a house. Over the past two months long-term mortgage rates — which are set by investors bidding on the price of money in the credit markets — have shot up half a percentage point.

For all the hoopla about the Fed’s interest rate deliberations, the central bank has only limited control over day-to-day changes in rates that home buyers pay. The official “federal funds” rate applies to very short-term loans — typically money that banks move around overnight to make sure they have enough reserves on hand.

The federal funds rate effectively becomes the wholesale price for money. When banks lend that money to you through your credit card or some other lending vehicle, they charge much more than they paid for it. That’s where bank profits come from.

(If banks can't get enough funds from each other, they can go directly to the Fed and borrow from the “discount window,” but they pay a rate that is generally set a percentage point above the federal funds rate.)

Banks are not the only place to borrow money. Big borrowers — like investment banks, corporations or big mortgage companies — can “buy” money directly from investors through a global trading network of dozens of different types of paper referred to collectively as “the credit market.” The biggest issuer of such securities is the U.S. Treasury. Corporations, government agencies, and other big borrowers also churn out trillions of dollars worth of paper and offer it up directly to get the best price they can for the raw material they need — money.

Investors bid on that paper, agreeing to part with their money for a fixed term in return for a regular interest payment (sometimes called the “coupon” because holders once had to actually clip a coupon from the printed paper and and mail it in to get their interest payment.) The  price is set, second by second, in a global auction that matches up sellers of paper (borrowers) with investors who are lending them money.

If you’re an investor, one of the most important considerations is the risk that you might not get your money back. If the risk is higher, the investor will demand a higher interest rate, just as a bank charges higher interest rates to people with bad credit.

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