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023 How the Fed Influences Interest Rates - A Refresher
Prof. Chris Palmer, UC Berkeley...
Influencing Long Term Interest Rates
The central bank of a country is tasked with changing interest rates and changing the money supply to try to smooth out economic fluctuations to prevent runaway inflation and to keep employment at full growth. Their task is to stabilize the national economy and the way that they do that is by moving around short-term interest rates.
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Measuring QE Impact
But the question is, does this really work and if it does, how does it work exactly because without seeing the full scope of consequences of such monetary policy there may be unexpected consequences that are more damaging than the problem we were originally attempting to solve. At Berkeley university there is a vast database of anonymized data on properties, on mortgages, and on refinances that is used to assess the impact of these policies on the market.
Conforming vs. Jumbo Loans
Quick aside. Fannie and Freddie buy and guarantee residential mortgage loans that meet several criteria. The loans must have at least 20% down payment, for example, it has to be below the ‘conforming’ loan limit which is in the neighborhood of around $500,000. If it a loan is higher than the defined conforming limit, it is ineligible for purchase by Fannie or Freddie. The Fed is restricted to buying loans guaranteed by Fannie and Freddie so for those communities where house prices are substantially higher than the conforming limits, then the mortgage amounts will be higher also - jumbo loans - so the theory is that these communities would not directly benefit from the QEs which were restricted to only buying conforming loans.
Tapering QE
Going forward there is less likelihood that the Fed will continue with quantitative easing. As mortgages are paid off because someone sells their home or otherwise pays down their debt, the Fed reinvests the principle that is paid back by buying more Fannie and Freddie debt. One way to taper off the QE stimuli to slowly increase long term interest rates is to stop buying back Fannie and Freddie loans with principle that is paid back. As this happens, the long-term end of the yield curve will start to see an uptick in interest rates and consequently pricing will start to soften and cap rates will go up.
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