However, for the most part, these rates rarely vary from the target rate. This is because the banks know that the Fed will use its other tools, such as the discount window, discount rate and reserve balance supply, to create pressure on the Fed funds rate to meet its target.
On September 18, 2007, the Fed began a 16-month drive to dramatically lower rates, from 5.25% to less than 1%. This was in response to tightening credit markets brought on by the subprime mortgage crisis.
By January 2010, investors began wondering "When will the Fed raise interest rates again?" In response, the Fed announced its exit strategy, which focused on tightening money supply using everything BUT the Fed Funds rate. The Fed wants to keep that rate low, since it affects variable-rate mortgages. The housing market had not yet recovered, since it had a 15-month pipeline of foreclosures that kept housing prices down.
The Fed also must compensate for expansionary fiscal policy. On June 1, 2010, the U.S. debt hit $13 trillion. The $787 billion stimulus bill and the FY 2010 budgetrequired record level funding from Treasury auctions. China began backing away from purchasing this debt, driving Treasury yields as higher. The yields on 10, 15 and 30-year Treasury bonds affect fixed-rate mortgage interest rates.
Therefore, the Fed's goal is to keep the Fed Funds rate unchanged as long as possible by increasing the discount rate and cutting back on other programs. This will keep the prime rate and variable-rate mortgages low, support the housing market and keep bank credit available. (Article updated June 3, 2010)
