The American economy, like most world economies today, is run on a system of fiat money, or money that is assigned its value by government decree. Since this money has no intrinsic value of its own, its value and supply must be carefully managed and regulated, not just within the nation’s borders but also in accordance with the economies of all other nations. In light of this need for careful stewardship of the economy, the United States maintains a central bank, called the Federal Reserve (or, more commonly, the Fed).

The Fed as it exists today is actually the United States’ fourth attempt at founding a central bank. In the midst of the Revolutionary War, America’s Continental Congress ratified the Articles of Confederation, which, among other edicts, gave Congress the power to issue bills of credit. A private national bank, modeled after the Bank of England, was established shortly thereafter, but was denied the opportunity to become a central national bank due to unease about foreign influence and other political concerns. The official First Bank of the United States was created in 1791, and lasted 20 years before being denied a renewal of charter by President James Madison. The Second Bank of the United States opened in 1816, and it too only lasted 20 years before President Andrew Jackson shut it down. Political opposition to the very idea of a central bank had been a chief culprit of these failures, and it would be almost a century before the United States would try again.

In 1907, a profound financial panic occurred, a direct result of a failed attempt by stock traders to corner the market on shares of the United Copper Company. The failure created a series of bank runs on those institutions that had backed the bid. As is often the case with bank runs, the atmosphere of worry spread nationwide, causing other banks to suffer runs and even leading to the collapse of, at the time, the third-largest financial trust in New York City, the Knickerbocker Trust Company. With no central bank in existence to attempt stabilization of the economy with an infusion of currency, the only reason that the crisis did not fling the country into irreparable economic turmoil was the work of private business tycoons such as J.P. Morgan, who banded together and contributed much of their own capital to bolster the banks. It was this barely dodged catastrophe that led to a series of financial reforms over the next few years, culminating in 1913 when Congress and President Woodrow Wilson passed the Federal Reserve Act.

In structure, the Federal Reserve is unique among the world’s central banks. Although it is designed to function as an entity “independent” of the federal government, thereby limiting its exposure to political influence, the Fed also employs a mixture of private and public sections in its operation—most similar banks in the world operate under either entirely private or entirely public ownership. It is also the only such bank to not make its own currency (which is instead printed by the United States Treasury). The Fed is managed by a Board of Governors, all of whom are presidential appointees, and is also comprised of the Federal Open Market Committee (FOMC) and representatives from twelve other Federal Reserve Banks located throughout the country.

The Fed has been reformed a number of times since 1913, especially so after the recovery from the Great Depression. Currently, its chief mandate is to provide the means to deal with bank panics, but it also sets interest rates, operates as a lender of last resort in case the banking system is in need of capital, and generally regulates the entire money supply by balancing the factors of employment rates and inflation. The importance of these functions to the American economy cannot be overstated. Any competent financial player in any market knows that a key component of success or ruin is an ability to observe, analyze, and possibly predict the actions of The Fed…and any competent Board of Governors is aware that The Fed is being closely watched.

Market Comment
Mortgage bond prices rose last week, which helped mortgage interest rates improve slightly. The first portion of the week was generally bond friendly as the Fed minutes showed real concern about the economy’s ability to recover with so many job losses. Stocks and bonds generally traded inversely as the DOW tested the 11,000 mark a few times during the week in up and down trading. Unfortunately, a large portion of the improvements was erased as oil prices traded around $87/barrel and inflation fears emerged.

Rates still managed to improve by about 1/4 of a discount point for the week.

The consumer price index Wednesday will be the most important release this week. The abundance of important economic releases has the potential to result in a very volatile week for mortgage interest rates. If the data shows signs of weakness, we could see rates improve.

Oil
Inflation fears tied to rising energy prices have reemerged. At one point oil prices rose near $87/barrel last week causing many analysts to revise forecasts. Goldman Sachs and Morgan Stanley both predict oil prices will rise above $100/barrel next year. The concern is that rising energy costs could permeate through the markets and damage economies around the globe that are struggling to regain footing. Inflation, real or perceived, generally erodes the value of fixed income securities causing prices to fall and rates to rise. This could pressure mortgage interest rates higher further stifling a recovery in the US housing sector.

Market Comment
Mortgage bond prices moved considerably this week with rates rallying midweek as additional Treasury debt was absorbed. Foreign demand for the shorter-term auctions was surprisingly strong, while the longer-term auction was average. The US Treasury auctioned $963 billion of debt the first half of this year and is expected to offer $1.1 trillion in the second half. Weekly jobless claims were better than expected, which did not help mortgage bond prices. However, falling oil prices eased inflation fears and enabled mortgage bond prices to increase, which pushed rates lower. Oil was under $60/barrel last Thursday morning.

For the week, interest rates improved by about 1/2 of a discount point.

The consumer price index data Wednesday will be the most important data this week. Signs of inflationary pressures from any of the data releases will not bode well for mortgage interest rates.

Fed Minutes
In December 2004, The Federal Open Market Committee decided to reduce the lag time between the open market committee meeting and the release of the minutes from six weeks to only three weeks. The minutes from the meeting have the ability to cause mortgage interest rate fluctuation because they provide more policy details than the standard post meeting release. Most importantly, the minutes provide the Fed’s complete economic analysis and various opinions of individual Fed members. There is typically an overwhelming consensus among the members. However, there can also be dissension, causing uneasiness in the financial markets. The release often comes and goes without much uproar but if any of the text seems troubling to analysts, you can expect market changes.

Mortgage interest rates remain at historic lows. Capitalizing on current levels is wise amid the recent economic instability across the globe. Inflation fears could be stoked with continued Middle East tension and hurricane season heading our way. Inflation, real or perceived, generally does not bode well for mortgage bonds and could cause rates to rise.

Market Comment


Mortgage bond prices had another volatile week with rates pushing higher the beginning of the week only to bounce back towards the end. Thursday’s employment report was mixed. Non-farm payrolls fell 467,000 in June and the unemployment rate stood at 9.5%. Estimates were for jobs to decline 365,000 and the unemployment rate to stand at 9.6%. Fortunately the payrolls figure gained most of the attention along with falling oil prices and we recovered about 1/2 of a discount point Thursday morning. Oil was under $67/barrel Thursday morning, which helped alleviate inflation fears. The bond market was closed Friday for the holiday.

For the week interest rates were near unchanged.

Weather
The mortgage interest rate markets are subject to many factors. Most analysts agree that weather can have an effect on market activity. Although the effects are seldom long lasting, they can be quite significant.

The United States is the world’s largest exporter of corn. Last year, relatively rainy weather across the Midwest portions of the United States delayed the planting of corn. This caused corn prices to escalate. This year, corn farmers planted more acres of corn than analysts expected. Larger corn crops recently caused prices to fall. This is one bright spot amid heightened inflationary fears. Lower corn prices likely will result in lower food prices for some items.

The weather also has the potential to directly alter fuel prices. As we enter the hurricane season, many oil and gas fields in the Gulf, along with refineries along coasts, are susceptible to damage. If this were to occur, oil prices would rise sharply. Rising oil prices would do little to help mortgage bond prices, already pressured by inflationary fears and competition for investor funds from record debt levels. The result would most likely be higher rates.

The economic effects of weather may cause only temporary changes in economic activity. However, these changes can have a lasting impact on people obtaining mortgages. Despite recent rate fluctuation, mortgage interest rates remain historically favorable. Now is a great time to take advantage of rates at these levels.