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Two Fed myths that need debunking

Bernanke & Co. do not set interest rates, and they're not about to run out of money for bailouts.

There are some things Fed chief Ben Bernanke can't control - like long-term interest rates.

Bernanke's dark economic outlook

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NEW YORK (Fortune) -- 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 institutions that it deems worthy afloat. 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" when we talk about the Fed's control. That 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 Fed funds rate.

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

Since September, the Fed has reduced the Fed funds rate by 62% - to 2% from the previous 5.25%. But long-term mortgage rates are higher than on Sept. 18, when the Fed began its rate cuts, as you can see from the adjacent graphic, which is based on numbers from mortgage experts HSH Associates.

The rate on a 30-year fixed-rate conforming mortgage - "conforming" means that the mortgage is eligible for sale to mortgage guarantors Fannie Mae (FNM, Fortune 500) or Freddie Mac (FRE, Fortune 500) - was 6.44% the week before the Fed's first cut, and was recently 6.51%. Jumbo mortgages - mortgages too big to be considered conforming - were going for 7.63%, up from 7.26%. (All of these numbers include up-front points that borrowers pay, in addition to their basic interest rate.)

The Fed and Treasury - along with 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 mortgage lenders less eager to lend, and makes 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 panics that have been sweeping the 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 also argue that the Fed's lowering of short-term rates has raised inflation fears and contributed to the decline of the dollar 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.

Can the Fed afford it?

There's an idea out there that the Fed may run out of money or government securities as a result of the huge, high-dollar programs that it and the Treasury have launched, or could end up having to launch, to keep financial markets afloat.

Fed chief Ben Bernanke and his crew have recently embarked on two programs that have raised questions about how it can afford its commitments. First, it will now lend directly not just to commercial banks, but also to institutions, like investment banks. Second, it will now lend selected borrowers Treasury securities (which they can then sell or borrow against) in return for securities (like some mortgage-backed bonds) that can't be sold or borrowed against for anything close to their stated value.

The worry is that the Fed owns only about $800 billion of Treasury securities, and all these existing programs, not to mention possibly helping arrange huge loans to Fannie Mae and Freddie Mac under a bailout plan now being kicked around, would consume a total of more than $800 billion.

But that worry 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 the bank's account at the Fed, and the borrower can spend that 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 $800 billion of Treasury securities, it could buy them in the open market, and deposit the payment for them 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 you 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 that 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 mid-summer, 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.  

First Published: July 22, 2008: 10:32 AM EDT

RE = Residential

LD = Land

CI = Commercial

MF = Multi-Family

CN = Condominium

DOM = Days on Market

Market Statistics All MLS

Statistics for: Class=RE,LD,CI,MF,CN,RN AND Date Range=06/01/2007-06/30/2008 AND Area=Ventnor City NJ AND Board=-1; As Of: 7/22/2008

Class Bedrooms Current Active Avg List Price Avg DOM All All 458 $660,925 163 RE All 221 $882,572 153 RE 1 bedroom 2 $213,350 208 RE 2 bedroom 11 $338,536 157 RE 3 bedroom 87 $472,783 167 RE 4 bedroom 48 $858,304 130 RE 5 bedroom 73 $1,487,220 148 LD All 36 $719,405 187 CI All 16 $738,437 206 MF All 74 $498,290 177 CN All 111 $297,911 159 CN 1 bedroom 36 $242,391 146 CN 2 bedroom 52 $256,519 167 CN 3 bedroom 20 $443,455 162 CN 4 bedroom 3 $711,333 168 CN 5 bedroom 0 $0 0 RN All 0 $0 0 RN 1 bedroom 0 $0 0 RN 2 bedroom 0 $0 0 RN 3 bedroom 0 $0 0 RN 4 bedroom 0 $0 0 RN 5 bedroom 0 $0 0

Class Bedrooms Total Listed Num Sold Pct Sold Avg List Price Sold Avg Sale Price Sold Sale Price/List Price Ratio Avg DOM Sold Avg List Price Unsold Pct Expired All All 892 230 25.78% $548,519 $486,269 88.65% 119 $609,949 39.46% RE All 441 122 27.66% $723,104 $641,991 88.78% 105 $834,103 33.56% RE 1 bedroom 7 1 14.29% $325,900 $325,900 100.00% 129 $434,580 42.86% RE 2 bedroom 27 10 37.04% $288,640 $258,850 89.68% 60 $342,664 33.33% RE 3 bedroom 177 54 30.51% $362,181 $335,709 92.69% 118 $416,058 32.77% RE 4 bedroom 91 29 31.87% $796,575 $708,293 88.92% 121 $813,824 32.97% RE 5 bedroom 139 28 20.14% $1,512,428 $1,312,135 86.76% 78 $1,430,224 34.53% LD All 47 3 6.38% $997,966 $718,333 71.98% 240 $667,256 29.79% CI All 24 8 33.33% $332,200 $307,375 92.53% 206 $322,342 29.17% MF All 143 22 15.38% $417,813 $366,863 87.81% 119 $531,986 55.24% CN All 237 75 31.65% $307,963 $277,787 90.20% 129 $282,994 43.88% CN 1 bedroom 96 37 38.54% $255,127 $231,432 90.71% 122 $228,206 33.33% CN 2 bedroom 94 32 34.04% $332,803 $296,002 88.94% 131 $269,809 54.26% CN 3 bedroom 39 4 10.26% $489,975 $455,000 92.86% 167 $429,899 41.03% CN 4 bedroom 8 2 25.00% $524,000 $489,500 93.42% 167 $391,633 62.50% CN 5 bedroom 0 0 0.00% $0 $0 0.00% 0 $0 0.00% RN All 0 0 0.00% $0 $0 0.00% 0 $0 0.00% RN 1 bedroom 0 0 0.00% $0 $0 0.00% 0 $0 0.00% RN 2 bedroom 0 0 0.00% $0 $0 0.00% 0 $0 0.00% RN 3 bedroom 0 0 0.00% $0 $0 0.00% 0 $0 0.00% RN 4 bedroom 0 0 0.00% $0 $0 0.00% 0 $0 0.00% RN 5 bedroom 0 0 0.00% $0 $0 0.00% 0 $0 0.00%

Market Statistics All MLS

Statistics for: Class=RE,LD,CI,MF,CN,RN AND Date Range=06/01/2006-06/30/2007 AND Area=Ventnor City NJ AND Board=-1; As Of: 7/22/2008

Class Bedrooms Current Active Avg List Price Avg DOM All All 458 $660,925 163 RE All 221 $882,572 153 RE 1 bedroom 2 $213,350 208 RE 2 bedroom 11 $338,536 157 RE 3 bedroom 87 $472,783 167 RE 4 bedroom 48 $858,304 130 RE 5 bedroom 73 $1,487,220 148 LD All 36 $719,405 187 CI All 16 $738,437 206 MF All 74 $498,290 177 CN All 111 $297,911 159 CN 1 bedroom 36 $242,391 146 CN 2 bedroom 52 $256,519 167 CN 3 bedroom 20 $443,455 162 CN 4 bedroom 3 $711,333 168 CN 5 bedroom 0 $0 0 RN All 0 $0 0 RN 1 bedroom 0 $0 0 RN 2 bedroom 0 $0 0 RN 3 bedroom 0 $0 0 RN 4 bedroom 0 $0 0 RN 5 bedroom 0 $0 0

Class Bedrooms Total Listed Num Sold Pct Sold Avg List Price Sold Avg Sale Price Sold Sale Price/List Price Ratio Avg DOM Sold Avg List Price Unsold Pct Expired All All 899 238 26.47% $536,949 $485,875 90.49% 112 $648,542 32.93% RE All 430 126 29.30% $715,015 $636,974 89.09% 113 $889,009 30.23% RE 1 bedroom 2 1 50.00% $994,999 $830,000 83.42% 92 $250,000 0 RE 2 bedroom 30 11 36.67% $246,090 $224,086 91.06% 172 $310,728 16.67% RE 3 bedroom 183 60 32.79% $409,554 $382,890 93.49% 84 $487,129 31.69% RE 4 bedroom 101 23 22.77% $676,669 $601,695 88.92% 105 $914,028 28.71% RE 5 bedroom 114 31 27.19% $1,492,041 $1,295,206 86.81% 155 $1,610,390 33.33% LD All 22 2 9.09% $387,450 $290,000 74.85% 189 $804,692 36.36% CI All 22 4 18.18% $292,425 $266,875 91.26% 95 $460,609 77.27% MF All 154 24 15.58% $476,187 $432,458 90.82% 128 $525,068 33.12% CN All 271 82 30.26% $296,695 $284,793 95.99% 105 $326,489 33.21% CN 1 bedroom 104 31 29.81% $243,316 $224,730 92.36% 102 $282,181 31.73% CN 2 bedroom 124 36 29.03% $294,347 $279,163 94.84% 114 $314,502 34.68% CN 3 bedroom 33 13 39.39% $431,130 $445,115 103.24% 81 $426,792 33.33% CN 4 bedroom 10 2 20.00% $292,500 $275,000 94.02% 140 $443,783 30.00% CN 5 bedroom 0 0 0.00% $0 $0 0.00% 0 $0 0.00% RN All 0 0 0.00% $0 $0 0.00% 0 $0 0.00% RN 1 bedroom 0 0 0.00% $0 $0 0.00% 0 $0 0.00% RN 2 bedroom 0 0 0.00% $0 $0 0.00% 0 $0 0.00% RN 3 bedroom 0 0 0.00% $0 $0 0.00% 0 $0 0.00% RN 4 bedroom 0 0 0.00% $0 $0 0.00% 0 $0 0.00% RN 5 bedroom 0 0 0.00% $0 $0 0.00% 0 $0 0.00%

RE = Residential

LD = Land

CI = Commercial

MF = Multi-Family

CN = Condominium

DOM = Days on Market

Market Statistics All MLS

Statistics for: Class=RE,LD,CI,MF,CN,RN AND Date Range=06/01/2007-06/30/2008 AND Area=Atlantic City NJ AND Board=-1; As Of: 7/17/2008

Class Bedrooms Current Active Avg List Price Avg DOM All All 978 $671,775 168 RE All 304 $528,675 142 RE 1 bedroom 2 $279,500 139 RE 2 bedroom 29 $270,744 171 RE 3 bedroom 172 $351,258 137 RE 4 bedroom 68 $588,984 136 RE 5 bedroom 33 $1,570,884 150 LD All 132 $1,125,505 206 CI All 81 $2,328,065 236 MF All 136 $477,266 168 CN All 325 $289,942 160 CN 1 bedroom 178 $206,118 164 CN 2 bedroom 91 $384,629 149 CN 3 bedroom 52 $375,998 161 CN 4 bedroom 4 $747,225 191 CN 5 bedroom 0 $0 0 RN All 0 $0 0 RN 1 bedroom 0 $0 0 RN 2 bedroom 0 $0 0 RN 3 bedroom 0 $0 0 RN 4 bedroom 0 $0 0 RN 5 bedroom 0 $0 0

Class Bedrooms Total Listed Num Sold Pct Sold Avg List Price Sold Avg Sale Price Sold Sale Price/List Price Ratio Avg DOM Sold Avg List Price Unsold Pct Expired All All 1,773 326 18.39% $323,930 $283,663 87.57% 111 $519,043 48.05% RE All 587 111 18.91% $289,849 $261,649 90.27% 92 $443,873 50.09% RE 1 bedroom 4 0 0.00% $0 $0 0.00% 0 $181,333 75.00% RE 2 bedroom 47 13 27.66% $192,211 $176,761 91.96% 134 $239,405 46.81% RE 3 bedroom 345 74 21.45% $210,758 $194,773 92.42% 86 $339,679 49.86% RE 4 bedroom 117 13 11.11% $488,815 $425,453 87.04% 86 $558,641 44.44% RE 5 bedroom 74 11 14.86% $702,163 $618,272 88.05% 86 $832,203 60.81% LD All 172 29 16.86% $235,193 $155,986 66.32% 112 $643,423 36.05% CI All 120 10 8.33% $1,178,590 $958,650 81.34% 134 $2,124,892 42.50% MF All 251 29 11.55% $259,437 $234,275 90.30% 90 $473,542 58.57% CN All 643 147 22.86% $321,753 $289,299 89.91% 128 $285,702 46.35% CN 1 bedroom 381 97 25.46% $224,555 $201,814 89.87% 132 $217,367 54.33% CN 2 bedroom 177 38 21.47% $436,902 $403,355 92.32% 115 $354,655 39.55% CN 3 bedroom 79 11 13.92% $656,236 $568,500 86.63% 132 $413,932 25.32% CN 4 bedroom 6 1 16.67% $1,695,000 $1,370,000 80.83% 185 $979,475 16.67% CN 5 bedroom 0 0 0.00% $0 $0 0.00% 0 $0 0.00% RN All 0 0 0.00% $0 $0 0.00% 0 $0 0.00% RN 1 bedroom 0 0 0.00% $0 $0 0.00% 0 $0 0.00% RN 2 bedroom 0 0 0.00% $0 $0 0.00% 0 $0 0.00% RN 3 bedroom 0 0 0.00% $0 $0 0.00% 0 $0 0.00% RN 4 bedroom 0 0 0.00% $0 $0 0.00% 0 $0 0.00% RN 5 bedroom 0 0 0.00% $0 $0 0.00% 0 $0 0.00%