Interest Rate Link Explained

In a recent story regarding increased home sales ("County's 63% Increase in Home Sales Leads Southland," April 25), you quoted a real estate agent who claimed that home buyers should not expect interest rates to decline further because of the Federal Reserve's reluctance to cut the discount rate.

I would like to clarify that higher short-term interest rates are not inconsistent with lower, long-term, fixed mortgage rates. Long-term rates are extremely sensitive to inflation expectations.

If higher short-term interest rates restrain current economic and money-supply growth, inflation pressures will ease, as will inflation expectations. This decline in inflation expectations would lead to a reduction in long-term mortgage rates rather than an increase.

The Federal Reserve's recent action to cut short-term rates was based on the belief that inflation was under control. If the Federal Reserve is correct, long-term, fixed mortgage rates should decline with short-term rates. If, however, the cut proves inflationary and inflation expectations increase, long-term, fixed mortgage rates would actually increase in response to the short-term rate cut. Thus, the effect of lower short-term interest rates on long-term rates hinges on inflation expectations.



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