Two Fed Myths That Need Debunking

There are two things you may have heard about the Federal Reserve Board, both of which are wrong.

The first is that the Fed controls U.S. interest rates.

The second is that the Fed has made so many commitments that it's in danger of running out of cash or Treasury securities. Which would mean it couldn't carry out its declared policy of putting cash into the world financial system, or its undeclared policy of keeping afloat institutions that it deems worthy. Let me show you why both of these beliefs are myths, not reality.

Let's do interest rates first. It's the more common myth, created partly by sloppiness among people in my business who write (and say) things like, "The Fed cut interest rates today."

In fact, we should always insert "short-term" before "interest rates." That's because the Fed controls only some short-term rates, primarily the so-called federal funds rate that financial institutions charge each other for overnight loans. The financial markets set long-term rates, which often don't move in the same direction as the federal funds rate.

The case in point: the relationship -- or lack of one -- between the federal funds rate and the interest rate on long-term mortgages.

Since September, the Fed has reduced the federal funds rate by 62 percent -- to 2 percent from 5.25 percent. But long-term mortgage rates are higher now than they were on Sept. 18, when the Fed began its rate cuts.

The rate on a 30-year, fixed-rate conforming mortgage -- "conforming" means that the mortgage can be sold to mortgage guarantors Fannie Mae or Freddie Mac -- was 6.44 percent the week before the Fed's first cut and was recently 6.51 percent. Jumbo mortgages -- those too big to be considered conforming -- were going for 7.63 percent, up from 7.26 percent. (All of these numbers include upfront points that borrowers pay, in addition to their basic interest rate.)

The Fed and Treasury and many of the world's big financial players would love to have U.S. mortgage rates decline because that would lend support to home prices, which could use it.

Falling home values -- what we have in most U.S. housing markets -- increase foreclosures, which increase borrowers' pain and lenders' losses. The declining value of houses as collateral for mortgages makes lenders less eager to lend and potential home purchasers far less eager to buy. It's a vicious cycle that will end sooner or later -- everything does -- but it's not something that the Fed (or any individual regulator or player) can control.

The Fed cut short-term rates to help mitigate the panic that has been sweeping world financial markets for more than a year. In addition, those lower rates -- in theory, at least -- help prop up the U.S. economy.

But you can argue that the Fed's lowering of short-term rates has raised inflation fears and contributed to the dollar's decline in international markets, which in turn has affected commodities prices, whose massive increases are a major factor in U.S. inflation. So repeat after me: The Fed can set only short-term rates. Which may contribute to having long-term rates act in ways that the Fed didn't intend and doesn't particularly like.