FED setting interest rates question

[LovePrevails]

I was speaking to a socialist on facebook, and said something like this: 

"you recently posted a picture implying that the free market leads to homelessness, but the facts are the main factors in rising prices over the last decades have NOT been market driven. It was the state that artificially lowered interest rates so that people borrowed above their means and kept buying houses, pushing up the price. This favoured rich people who could buy up properties over first time buyers. 

then they kept printing money to pay for bribing the electorate and corporate interests, which inflates the currency and also makes the prices going upthen there was freddie mac and fannie may which massively increased the price of houseshouse prices went up 10x since the 70s largely due to state intervention - but for some reason you insist this is to do with the market? "

 

(If I missed any other ways how government drove up house prices please let me in for future

reference and my own general knowledge)

 

 

 

 People replied:

 

 

The fed lowered interest rates to 1%. are you saying people who wanted to buy homes were able to borrow money at 1%?

 

 

which is a straw man

 

 

and someone else said

 

 

The interest rate The Fed sets only effects the rates banks pay each other to borrow money and how much banks pay in interest on savings. The rest of us pay much different rates of interest to borrow money, notice your credit card rate isn't anywhere near 1%.

 

isn't that  the height of economic ignorance?

can someone give me a decent concise explanation of why the price fixing of interest rates does affect how much we pay when we borrow or how much we earn when we save

 

*Facepalm*

 

"Capitalism and deregulation caused the housing bubble and financial crisis. The Fed had no choice but to lower rates because the economy was already collapsing as a result of the deregulation that led to the dot com bubble. The 1% interest rates enable the speculators to go crazy with leverage, something they wouldn't have been able to do if regulations were still in place."

[Lowe D]

Because it is a currency issuer, the US Treasury has impeccable credit.  To pay back the money it has borrowed, it has only to issue more bonds, creating more currency in the process.      This means there is no default risk.  Nor is there any call risk: calling a bond is when the issuer recalls the bond and reissues it at a different (i.e. lower) rate.  Think re-financing with a mortgage. 

 

While municipal debt, corporate debt, mortages, and auto-loans have these serious risks, the only risk on Treasury bonds is that inflation runs higher, reducing real returns.

 

If Treasury debt is virtually risk-free, why would anyone ever buy the alternatives?  Well, they aren't giving you that mortage unless they can charge higher interest than they could with a Treasury bond of similar maturity.  Higher the risk means higher return.  This is why rates are generally higher on bonds of longer maturity, and why rates are universally higher on alternatives to Treasurys.

 

Imagine the Federal Reserve increases its purchases ofTreasury bonds on the secondary market.  This means the price of those bonds increases.  The Treasury notices this, so when they open their next auction, they know they can offer somewhat lower yields, and get the same price they had been getting only recently on the higher yields.  In this way yields move inversely to the price: lower in this case.

 

Now imagine you are a banker and this happens.  No more easy loans to Uncle Sam.  Which means its time to make some more risky business loans, consumer loans, and student loans, and in so doing lower the rates on all these loans.  Whatever you have to do to get your shareholders a profit, while maintaining an acceptable risk profile.  But what if rates are held down for too long?  What happens to your risk profile then? 

Short version:

 

All bond yields, to any debtor and for whatever purpose, move the same way as Treasury yields.  It's something you can observe in the financial news.  When Treasury yields decrease, so do mortage rates.  The positive difference between mortage and Treasury yields is a just a premium on the greater risk of the former.

 

Someone who doesn't understand this has no business being a socialist, or having opinions on politics or economics.  Which is exactly why they don't.  Their opinions are on the ghosts and goblins they have projected into the world, including the goblin they are projecting onto you.

[LovePrevails]

true or false:

the rate the fed lends money to banks has an effect on how much interest those banks charge on loans and offer on savings

[Wesley]

All interest rates are linked to the Fed rate. If it is a loan, then they get money from the Fed at 1% they will loan at 5% and make 4%. If they get money at 5%, they need to give a loan at 9% to make money.

 

For savings, if they get free money they have no need for your savings. Savings interest is the rate to entice you to loan to them. If the fed rate is 5%, they may have a savings rate at 4-5% to get money a bit cheaper and be able to loan that money out. If they get free money, then the savings rate will be almost nothing (as it is) because they could care less about your money. They get free money anyway.

 

Thus, true

[Lowe D]

The interest the Fed charges banks on loaned reserves is not large.  It's called the Federal Discount Rate, and it is 0.75% now.  I don't know what the maturity on these loans typically is, but I am sure it is very short.

 

H/e the Fed won't loan money to banks unless they have exhausted their reserves but can show there are still credit-worthy borrowers.  So generally when a bank is borrowing money through the Fed it borrows from other banks, which also store reserves with the Fed.  This is done at the Federal Funds Rate (FFR), which is 0.25% now.

 

The yield on treasurys is more important than these rates, in determining the rates on mortgages, commercial loans, etc.  This is because banks do not keep large cash reserves with the Fed or elswhere, if they can help it.  As of now the rate on the 10-year Treasury is 2.66%, which is way better than loaning money to other banks at 0.25% (bleh).

 

So the Fed mostly controls yields through its purchase and sale of US Treasury bonds, also known as its open market operations.  This is not to say that the FFR and reserve requirement aren't important, but not as important.  Both have been close to zero, or zero, for a while now.

 

So, the statement is true to a degree, but mostly the Fed spends its time worrying about Treasury yields.  That is how you ought to explain it, because it is closer to the truth, even if the reader are less likely to understand it.  If you're lucky you might even inadvertantly discourage yourself from trying, but instead spend more time learning about it yourself.  Their lack of knowledge will only hurt them.  And yours, well, you get it.

[Lowe D]

I have to apologize, because I'm projecting my own confusion and desires on to other posters. The FFR has historically been set via open market operations, on short-term Treasury debt, with long term debt like mortgages being affected by arbitrage against the FFR (like Wesley describes). This has been the most important Fed tool in setting rates, since the 1980s.

 

It's more recently that the Fed has used Treasury purchases to encourage lending, and to prop up equity, w/o regard to the FFR. They can now set the FFR explicitly, by setting the interest they pay on reserves (since 2008).