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8/31/2003

Master of the Puppets

by Tony Kindelspire
The Daily Times-Call

LONGMONT — He isn’t E.F. Hutton, but when he talks, people listen.

Alan Greenspan, chairman of the Board of Governors of the Federal Reserve System since 1987, is perhaps — aside from the president — the most-watched man in Washington.

When Greenspan dips his toes into the economic waters, ripples are felt from the Potomac to the South St. Vrain — and far beyond.

How does what “the Fed” does affect all of our pocketbooks? In more ways than most of us imagine.

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In June, during the most recent meeting of the Federal Reserve’s Open Market Committee, policymakers lowered the benchmark federal funds rate — the interest that banks charge each other for overnight loans — a quarter-point, to 1 percent.

The last time the rate was that low was 45 years ago. In 1958, Dwight Eisenhower was president, Leave It To Beaver was in prime time, and the country was going through its worst recession since World War II. Nearly 5.5 million people were out of work, and the unemployment rate hovered near 7 percent.

Things don’t seem as dire today. The national unemployment rate was 6.4 percent in July, but the people who track such things insist that the recent recession is well behind us. Lately, the economy has been showing more positive signs of improvement than we’ve seen in many months. So, what gives? Why is the Fed continuing to drop interest rates?

“As far as the public goes, there’s a lot of mystery to what the Federal Reserve does and what it means,” said Michael Stutzer, director of the Burridge Center for Securities Analysis and Valuation at the University of Colorado’s Leeds School of Business.

Stutzer, who teaches finance, used to work for the Federal Reserve as a senior economist at the bank’s Minneapolis branch.

It’s not easy to get Stutzer to forego “economist-speak” and break down Greenspan’s actions in a way that most of us can understand. He himself allows that the issue of interest rates can be “pretty complicated.”

There is the federal funds rate, which is the Fed’s main benchmark, and then there are a myriad of other rates that take their cues from it, including the rates placed on long-term treasury bonds, short-term “T-bills” and so on.

The prime rate, on which adjustable rate mortgages and credit card rates are partially based, is the rate at which banks will loan their “most preferred” customers money. It was lowered to 4 percent in June.

“Any one of those rates can have a lot to do with any of the others,” Stutzer said. “Borrowing and spending can affect the growth of the economy and the growth rate of inflation.”

June’s action was the 13th time the Fed had dropped the federal funds rate since 2001, all in an effort to revive the economy, Stutzer said.

“Making overnight rates low ... it creates money,” he said, adding that although a quarter-point might not sound like it’s creating a lot of money, “it can have a pretty big impact overall.”

Two cases in point: the bond market and long-term mortgage rates.

Bond prices recently have been dropping, which can be good or bad news, depending on who you are.

If you jumped out of the stock market when high-tech imploded and corporate scandals made daily news, bonds seemed like a safe haven for your money.

“Last year, everybody was getting out of stocks and buying bonds,” said Bill Stone, investment representative with Edward Jones. “That was the big thing last year. This year, everybody opened up their July (bond) statements and about fell out of their chair.”

It’s been a “tumultuous last couple of months” for the bond market, Stone said. In July, “bond prices saw their worst month since 1984.”

Bonds have an ironic link to the overall economy.

When the economy is going poorly, and people are buying fewer stocks, bonds generally will pay a higher rate of return. That’s good for bond investors, but bad for lenders — like banks.

Conversely, as the economy picks up and interest rates rise, the more the value of existing bond prices is lowered.

“Low interest rates for the borrower is good, but low interest rates for the entity that’s taking the income — then all of a sudden return on their money is much lower,” Stone explained.

There are also distinct differences between short- and long-term bonds, Stone said. Long-term bonds — “10 years and out” — are driven by market prices. The market, however, takes its cue from short-term rates, which are very much driven by the actions of the Federal Reserve.

The key thing for investors to remember, Stone said, is that as long as they hold the bond, they will get all of their money back once the bond reaches maturity. Watching their dividend payments drop, however, can lead some to decide to cash their bonds in early, which can result in a loss on their investment.

“One of the things that drives long-term interest rates is the fear of inflation,” Stutzer said. “If the banks really fear inflation, they’re going to seek higher interest rates up front.”

And that’s what is driving the recent jump in long-term mortgage interest rates.

Interest on 30-year, fixed-rate mortgages averaged less than 5 percent nationally as recently as the middle of June, but since then they have spiked dramatically. So far, housing prices have not been affected, but the number of people refinancing their homes has fallen off dramatically.

“Refinancing now is about 20 percent less than it was at this time last year, and that’s going to continue,” Stutzer said.

“The applications for refinancing have dropped off pretty significantly in the past three or four weeks,” agreed Marty Quigley, broker associate with Prudential LTM Realtors.

As with bond rates, there can be both good and bad news associated with higher long-term mortgage rates.

The mortgage market in the United States, said Stutzer, is larger than the U.S. Treasury market. And it’s not just the actual mortgage companies that have a stake in that market.

“The ownership of those mortgages are not just the original lenders of those loans — the banks,” said Stutzer. “That’s just the first step.”

Instead, he suggested that the broad term “mortgage market” might best be described by a scene from the Christmastime classic, “It’s A Wonderful Life.” The scene where Jimmy Stewart — as George Bailey — tells the townspeople who are making a run on his savings and loan, “The money’s not here. Your money’s in Joe’s house ... right next to yours. And in the Kennedy house, and Mrs. Macklin’s house, and a hundred others.”

In other words, mortgage loans are spread out through a thousand other layers of the economy. Many mutual funds, Stutzer said, have a stake in the mortgage market.

Higher long-term rates means more money returned to the holders of mortgages, and that money ultimately makes its way out into the economy at large through these many other channels.

For the homebuyer, however, higher rates simply means higher monthly payments — i.e., less money in their pockets.

Consumers might have loved the low mortgage rates — as evidenced by the number of homeowners who refinanced — but Stutzer said the lenders most decidedly did not.

“They’re getting a stream of payments back that they could have been getting at a higher rate,” he said.

Some believe the spike in long-term rates was an unwanted side effect of the Fed’s move in June.

“They went the opposite of what (Greenspan) wanted them to do,” said Terry Christensen, a loan officer with Dominion Mortgage Corp. “He didn’t want long-term rates to go up. But we think the reason they went up is people are believing the economy is on the way back.

“When the stock market gets better, long-term rates usually go up.”

Whether the Fed will make any adjustments to the federal funds rate when it meets again in two weeks is anybody’s guess. But all eyes will be on the 12 members of the Fed’s Open Market Committee when it meets Sept. 16, waiting to see if yet another drop will be necessary or if the economy is continuing to show signs that a true recovery is, indeed, under way.

“The thing about growth is it always brings inflation,” Stone said. “That’s one of the intangibles that’s always eating away at your money — inflation.

“To control inflation is to control growth, and that’s the Federal Reserve’s job. That’s what their purpose is.”