Saving the Economy May Hurt Mortgage Rates

Starting in 2007, the Fed voted to progressively cut mortgage rates, and within the first quarter of 2008, slashed them dramatically and severely. This reduction was an effort to provide needed liquidity to the mortgage and real estate industries. But now, with inflation our greatest economic threat, rates may rise. Such a shift in monetary policy could be painful for consumers.

The Federal Reserve is faced with a classic conundrum. If it cuts interest rates, it might help to fend off a recession. Raising rates, on the other hand, helps combat inflation. Right now, we're in between, and the economy is being simultaneously attacked on two fronts. Caught in the middle are average consumers. They're like ants on a log that's burning on both ends. The situation is especially dire for those trying to get a mortgage or refinance a loan.

Classic mortgage rate dilemma

Here are some reasons why there's no easy answer:

• Keeping interest rates low eases problems for consumers and businesses that need capital in order to pay bills, make major purchases, and revitalize a slow economy. But the lower that rates plunge, the weaker the dollar becomes. This creates inflation, which makes it too expensive to pay for basic necessities.
• Part of the solution is to strengthen the dollar by raising interest rates. That's exactly what the Fed has indicated it will do in the coming months. This change in Fed policy should bring down prices of commodities like gas and food, and help support the economy.
• Higher rates will drive the cost of consumer loans and mortgages up at a time when most Americans desperately need to borrow emergency funds. Without a way to refinance out of troublesome loans, for instance, millions of homeowners will likely slide closer to foreclosure.

Prices up, happiness down

The cost of the goods that banks and mortgage companies sell-namely, the cash they lend to customers-goes up when rates rise. Having to pay more to borrow from the Fed, they usually pass that cost directly along to their customers. That's bad news for borrowers, but this year, the outlook is even worse because banks have other headaches. The demand for their products-namely, bundles of mortgage loans sold to Wall Street investors-has fallen considerably since the subprime crisis began. Their stock prices and lending power have weakened as their business prospects became bleaker, and earnings suffered in a variety of ways. To save the overall economy, the Fed may have to raise rates, which will put added pressure on banks.

The big loser is the consumer who doesn't want to pay high prices at the grocery store and gas pump, but also wants more affordable credit card and mortgage payments. He can't have it both ways and, with a recession and inflation attacking simultaneously, the available cure may seem as bad as the disease itself.