Two Fed Myths That Need Debunking

By Allan Sloan
Tuesday, July 22, 2008

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.

Now, to the question of whether the Fed can carry out its commitments, spoken and unspoken. Some say the Fed may run out of money as a result of the huge, high-dollar programs that it and the Treasury have launched -- or could end up launching -- to keep markets afloat.

The worry is that the Fed owns only about $800 billion in Treasury securities and that lending to investment banks, adding to the liquidity of world markets, and possibly helping arrange huge loans to Fannie Mae and Freddie Mac would consume more than $800 billion.

But that overlooks the Fed's amazing power to create as much money as it needs -- out of nothing, as it were.

Here's how it works. If an institution borrows, say, $50 billion from the Fed, the Fed can just post a $50 billion credit to that bank's account at the Fed, and the borrower can spend the balance on whatever it wants. It is indeed as if the Fed created cash out of nothing.

And if the Fed somehow needed more than its $800 billion of Treasury securities, it could buy them in the open market and deposit their payment in the seller's Fed account. That way, the Fed could lay its hands on however many Treasury securities it needed.

Yes, I'll grant that this sounds odd -- but if you ask a Fednik how this all works, he or she would tell you what I've just told you. Except it would be dressed up in fancier language, with all sorts of explanations of how the Fed can do all this and still carry out its monetary policy.

Why am I bothering you with this stuff in midsummer, a time when I'd rather be off drinking something cold than trying to deal with the Fed?

Because myths get in the way of understanding. And if there were ever a time when understanding the Fed's powers -- and limitations -- matters, that time is now.

Allan Sloan is Fortune magazine's senior editor at large. His e-mail address isasloan@fortunemail.com.