Help me understand interest rates
November 12, 2010 4:55 AM   Subscribe

Why are mortgage interest rates currently so low?

Mortgage interest rates are historically low. In the 90s, 8 or 9 percent was common, and in the 80s rates were in the double digits.

What are some economic triggers that change interest rates in one direction or another? Which are things have large effect on them?

What would have to happen for the current interest rates to go back to where they were in the 80s and 90s? Or, has something fundamental changed with the economy that will help ensure that they're low for a long time?
posted by TheOtherSide to Work & Money (9 answers total) 2 users marked this as a favorite
The current federal funds rate is at an all time low to combat recession and deflation.

Generally speaking, the Federal Reserve always has to decide which evil to combat: inflation or low growth. A low interest rate is good for growth but bad for inflation, a high interest rate slows growth but also slows inflation.

Right now the economy is in such a bad shape that the federal funds rate was lowered to effectively zero.

Should the fear of inflation grow or the economy get better, the interest rates might very well rise again.
posted by Triton at 5:24 AM on November 12, 2010 [2 favorites]

Mortgages are long-term loans, and as such their rates tend to be driven by long-term expectations of inflation combined with the availability of money to lend.

As Triton points out, the Fed has made a lot of money available. The long-term expectations of inflation are also very low. Hence we have historically low mortgage interest rates.
posted by alms at 5:38 AM on November 12, 2010

Mortgage interest rate is loosely tied to federal funds rate. In an attempt to stimulate the economy the Federal Reserve cut the federal funds rate to particularly zero. The banks can now pretty much borrow the money for free from the Fed. The Fed also has been buying mortgage backed securities to stabilize the housing market. Changing federal funds rate is an important tool for the Fed to manipulate the interest rate, but since it is at zero now, the Fed has been using Quantitative Easing(a.k.a "Printing More Money") to inject more money into the economy. The last round of Quantitative Easing has been dubbed QE2.

Another way to think about interest rate is that it is a rent on the money borrowed. When supply of money greatly increased, the rent on the money has to go down.

QE2 has been terrible for saver. The nominal interest rate might be zero but if you factored in the inflation rate, the real interest rate is negative! So all the money sitting in the bank not earning any interest? It's losing its value every day.

I'm not sure about the 90s. But during the 80s the interest rates were in double digits because the inflation were in double digits. Paul Volcker, the Chairman of the Fed in early 1980s, raise the Fed Fund Rate 20% to sharply decrease the supply of money in order to tame the inflation. He did a great job of taming the inflation but he was fired by Reagan for these unpopular moves. No politician wants to campaign they'll increase your interest rate.

So to answer your question. The interest rate is low because the Fed injected a lot of money in the economy. The extra money slushing around could be dangerous because it could spark an inflation. Once the inflation take off, everyone can kiss the low interest rate good bye.
posted by Carius at 5:41 AM on November 12, 2010

Money is subject to supply and demand like anything else. When there's a lot of money sitting around doing nothing productive, borrowing it is cheap. When money is tied up doing other things, it's expensive to borrow because financial institutions are not going to lend you money at prices that are lower than they could get by investing it elsewhere.

Lots of things can effect the supply of money. The fed intentionally tweaks the economy by buying and selling T-bills and setting the Federal funds rate. Congress does it by buying stuff (e.g. missles and airlplanes). Inflation affects both supply and demand by making everything cost more. The list of influences is long.

Interest rates are likely to rise with the economy, but most predictions seem to be that the economy will recover quite slowly.
posted by jon1270 at 5:41 AM on November 12, 2010

Triton has given you the macroeconomics of the thing in a nutshell. In addition to fed manipulation, interest rates are based on at least two fundamentals (I'm sure there are more, but these seem like the most significant):

- risk of inflation. There is also a natural cause/effect component that connects interest rate and inflation. If I give you $100 now in exchange for $100 five years from now, part of what I'm charging you for is the diminished value of $100 in five years. So if I believe inflation will be high, I will feel that I have to charge you more.

- supply and demand. Like anything else, money gets more expensive when more people want it, and v/v. The demand for money is effectively lowered by the tighter credit restrictions and qualifying requirements after the 2008 mortgage meltdown. That is, as many people as ever would like to borrow it, but fewer people CAN. But depositors are still bringing the stuff in, and the banks must loan it - any funds that a bank is sitting on in excess of its necessary reserves is 'dead inventory." I know some bankers, and despite a relatively decent local economy (i.e. it's not sucking as hard around here as it is elsewhere), they are desperate to find and make quality loans (i.e. loans they believe can be paid back and which meet regulations). In that climate, bankers are going to compete with each other on interest rates.

And that, kids, is why I'm DESPERATE to sell my house so we can get a bit better one... unfortunately, the aforementioned qualification crunch means not many buyers in my price range are available.

I came of age in the late '80s timeframe, and those 12% auto loans and 8-9% mortgages were something of a historical aberration. IOW, rates are historically low now, but they were historically high then. My parents generation was accustomed to paying rates that were more like todays (say in the 5-6% range) I would not necessarily worry that those 8-9% days will come again soon, although it is of course possible.

I personally think (IANTFC*) that we will be in this rut for a while, at least a year.

*I Am Not The Fed Chairman
posted by randomkeystrike at 5:42 AM on November 12, 2010 [1 favorite]

on refresh - yeah, that damn Volker - I had forgotten about him. IMO, the Fed has gotten a lot better at doing this.

Another thing that should help keep interest down - the gov't owes more money than you do and is going to be reluctant to raise interest rates. :-)
posted by randomkeystrike at 5:45 AM on November 12, 2010

All these answers are correct. Especially the part about money as inventory.

A slightly different way to look at it: loans for you are investments for someone else. The interest rate charged is a combination of the risk in making the loan, the availability of other, better investments, and the timespan.

Risk as it applies to investing is kind of like insurance. I have to charge a premium (interest) based on the likelihood I am going to lose my principal, and the likelihood it is going to drop in value while I am lending it out. That's why credit cards charge such high interest- they are unsecured and a certain percentage of my investment principal is going to be lost. It is an almost certainty that I will lose part of my principal, so I have to charge a lot in order to make my target profit.

And what my target profit is depends on what other investments are out there. Right now, there aren't a whole lot of great investment opportunities out there- the economy isn't growing all that much and people are using up a lot of that growth to pay down debt and build savings. That is good for them, not so good for the investor. So there are a lot of investors out there with money that they need to invest.

That means supply is high and demand is low, which equals low prices. Which are interest rates in this case.

This effect is further exaggerated by the Federal Reserve in keeping the rates they pay at near zero. People loaning money to the government right now are barely breaking even when you account for inflation. So this increases the supply of loans even more- investors are clamoring to loan their money out (*) at ANY rate that's better than what they are getting from the Fed.

This is part of what the Federal Reserve is supposed to do- be a governor on the economy. Economists have found that too much growth is kind of like red-lining a motor. It can't be sustained, and when it breaks down it does so spectacularly. And on the other end, economists have found that zero or negative growth is really bad too. They do this by adjusting the money supply.

The money supply is important. Too much money and you get inflation. Too little money and you get deflation. Money is created and destroyed because much of our economy is leveraged- you deposit $100 in a bank, and they can lend out $90 of it. Now there is $190 created out of your $100. The 10% the bank keeps is called the reserve rate. The same thing happens with debt. I loan you $100. You have $100, and I have an asset (the note) worth $100. I can't use that money to buy anything, but I can use it as collateral to borrow money. The money supply needs to be in balance with the demand for money, which is the growth of the economy. Or the increase in value of all of our labor. If I buy $10 in supplies and sell it for $100, I have (very simplistically) increased demand against the money supply by $90. If I go out of business, the demand for money I was creating disappears.

Analogy alert! So, when you consider everyone everywhere doing all that kind of stuff, the money supply looks kind of like a water reservoir with all kinds of tributary rivers, and all kinds of entities sucking water out of it. In a perfect world, it all balances out on its own. But when things get out of whack, you get flooding (inflation) or water levels dropping (deflation). The Fed, in this scenario, acts as the water management agency, telling everyone what they can and can't do to the water level. They do this by changing the price of the water (interest rate) or by increasing the reserve requirement. (Which in this analogy would be the difference between how much water an entity takes in versus how much it takes out. It makes them store water unused.) If that doesn't do the job, they can also create rain or drought to literally create money out of thin air, or destroy money by evaporating it.

Where it gets complicated is that some of their tools only have effects in the future- saying they are creating a bunch of money makes people more confident in the current economy, but if they go too far, the money supply goes too high in a few years and they have to correct for it. That is where the free market or non-interventionists complain about the Fed- they believe that over-managing the money supply creates worse trouble than just leaving it alone. Sometimes they are right, sometimes they are wrong. The low interest rates of the early 2000's was meant to boost the economy as a whole, but instead created the real estate and investment bubbles.

(*) Clamoring, that is, for quality loans. It is a catch 22- they need to invest money so they are taking low rates. But in taking low rates, they need to make really sure that their investments are sound because there is very little profit available to take very much risk.
posted by gjc at 7:46 AM on November 12, 2010 [2 favorites]

What are some economic triggers that change interest rates in one direction or another?

- supply and demand for money

- government monetary policy (buying and selling government bonds, changing commercial bank and other depository institutions reserve requirements, discount window reserve rates)

- government fiscal policy (control money supply through government spending and taxation policies)

- expectations about inflation/deflation

Which are things have large effect on them?

- unemployment levels
- business cycles

What would have to happen for the current interest rates to go back to where they were in the 80s and 90s? Or, has something fundamental changed with the economy that will help ensure that they're low for a long time?

- For interest rates to rise significantly the economy would have to be experiencing an inflationary gap that the government would want to close by tightening up the money supply - as opposed to the current recessionary gap that the government is trying to close by loosening the money supply.
posted by stealabove at 8:26 AM on November 12, 2010

Another way mortgage rates could rise is excessive demand for mortgages. But for that to happen you'd need an economy going full steam and all the buyers on the sidelines rushing in to snap up homes. And before that would happen, the Fed would be raising interest rates, anyway, to combat inflation.

One thing to note, BTW, is that you can figure every full percent change to mortgage interest rates means that the monthly payment on a 30 year mortgage will rise or fall by 10%. This often has an effect on prices, but it's not anything like the effects the economy itself has on the housing market (or the rampant speculation that led to the housing bubble). What it really means is that how much house a buyer can afford changes with interest rates.
posted by dw at 1:01 PM on November 12, 2010

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