By John W. Schoen Senior Producer
updated 7/2/2007 10:29:57 AM ET 2007-07-02T14:29:57

The latest interest rate move by the Federal Reserve — a whole lot of nothing — has some readers, including Alvin in North Carolina, wondering why central bankers aren't doing more to help the ailing housing market by cutting rates. Hint: They're still worried about inflation. OK, asks Jeff in Sacramento, what exactly is inflation and what causes it?

If the housing market is in a slump, and it surely is, why is the Fed increasing the interest rates, which would make it even harder to qualify or get a loan mortgage?
—Alvin E., Belhaven, N.C.

In fact, the Federal Reserve’s latest move was to leave short-term interest rates just where they’ve been for the past 12 months. The Fed-controlled rate for banks borrowing money from each other remains at 5.25 percent. But that won’t help you if you’re trying to get a mortgage to buy a house. Over the past two months long-term mortgage rates — which are set by investors bidding on the price of money in the credit markets — have shot up half a percentage point.

For all the hoopla about the Fed’s interest rate deliberations, the central bank has only limited control over day-to-day changes in rates that home buyers pay. The official “federal funds” rate applies to very short-term loans — typically money that banks move around overnight to make sure they have enough reserves on hand.

The federal funds rate effectively becomes the wholesale price for money. When banks lend that money to you through your credit card or some other lending vehicle, they charge much more than they paid for it. That’s where bank profits come from.

(If banks can't get enough funds from each other, they can go directly to the Fed and borrow from the “discount window,” but they pay a rate that is generally set a percentage point above the federal funds rate.)

Banks are not the only place to borrow money. Big borrowers — like investment banks, corporations or big mortgage companies — can “buy” money directly from investors through a global trading network of dozens of different types of paper referred to collectively as “the credit market.” The biggest issuer of such securities is the U.S. Treasury. Corporations, government agencies, and other big borrowers also churn out trillions of dollars worth of paper and offer it up directly to get the best price they can for the raw material they need — money.

Investors bid on that paper, agreeing to part with their money for a fixed term in return for a regular interest payment (sometimes called the “coupon” because holders once had to actually clip a coupon from the printed paper and and mail it in to get their interest payment.) The  price is set, second by second, in a global auction that matches up sellers of paper (borrowers) with investors who are lending them money.

If you’re an investor, one of the most important considerations is the risk that you might not get your money back. If the risk is higher, the investor will demand a higher interest rate, just as a bank charges higher interest rates to people with bad credit.

For investors in the credit markets, the odds of an outright default by a borrower like a corporation or government agency is pretty low. Worries about rising mortgage defaults and foreclosures have pushed rates up a bit to make up for the higher risk to holders of mortgage-backed bonds. But the number of loans that may be in trouble is a small fraction (less than 2 percent) of all mortgage-backed bonds. With the economy relatively strong and overall wages rising, most homeowners are keeping up with their payments. So the risk is very low to all but the most risky mortgage-bond holders.

The bigger risk is that when your bond matures, and you get your money back, the dollars you receive won’t have the same purchasing power as the dollars you turned over when you bought the bond. The culprit there is inflation. If you invest $1,000 in a 10-year bond today, and inflation raises prices 3 percent a year, the $1,000 you get back in 10 ten years will be worth only $737.42 in today’s dollars. Put another way, 10 years from now you’ll need $1,343.92 buy the same goods and services you can get for $1,000 today.

That’s why the credit markets are so sensitive to inflation: If it looks like inflation is moving higher, interest rates go up to compensate bond buyers for the future erosion of their buying power. That’s one reason the Fed is so focused on keeping inflation in check. The Fed does have other weapons in its inflation-fighting arsenal. It can raise and lower the reserves it requires banks to maintain, and it can buy and sell from its own stash of Treasury bonds to move cash in or out of the credit markets. But as big as it is, the Fed controls only a small portion of the global capital markets. So while central bankers talk a good game, the market eventually has the last word.

Please define inflation and what causes it.
Jeff G., Sacramento, Calif.

Simple questions deserve simple answers. The definition is the easy part: Inflation is a rise in the prices of goods or services in a specific industry, region or economy over time. (When prices fall over time, that’s called deflation. When prices are rising but the rate of increase is slowing down that’s disinflation.)

As for inflation's causes, there are volumes of economic textbooks and piles of research papers on the subject. It’s a little like asking what causes a thunderstorm. The simple answer is: "Hot and cold air coming together." But the details are a lot more complicated.

In the case of inflation, the simplest answer is that prices go up when demand is stronger than supply. But that basic economic force shows up in many different ways and in many different places. If the available supply of oil, for example, doesn’t keep up with demand, the price goes up. As that happens, some demand goes away: As oil gets too expensive, some people stop buying it. But because oil is hard to do without, anyone who needs it has no other choice but to pay up.

That higher price of oil can push other prices up with it — everything from the price of plastics to the cost of delivering packages. The risk is that these increases spark more inflation further down the line.

If consumers have to pay higher prices for goods and services, and they go back and demand higher wages, their employers have to pass along that higher labor cost to customers, and the inflationary “spiral” begins. Economists talk about “demand pull” inflation (a surge in demand overwhelms supply) and “cost push” inflation (when rising costs ripple through the system). But no matter where it gets started, if it spreads too far, it begins to feed on itself.

Part of the menace of inflation is the psychological impact: Everyone assumes prices will go up, so they factor in higher wages and prices in everything they do, which becomes a self-fulfilling cycle. That’s why the Fed is so intensely focused on keeping the inflation genie in the bottle.

It’s been a while since we’ve seen runaway inflation in the United States. The last major outbreak was in the late 1970s and early '80s. Hard assets (like real estate or gold) provided some protection, but anyone who held financial assets (stocks or bonds) took a beating.

Policymakers tried everything. At one point, to beat back the inflationary bogeyman, the White House handed out “WIN” buttons — for “Whip Inflation Now.” But talk therapy didn’t work. By the early 1980s, consumer prices were rising at annual rate of more than 14 percent.

It wasn't until the Fed and credit markets passed that cost along to borrowers, pusing the  prime rate to 21.5 percent in December 1981, that the inflationary fever broke. Within two years, the inflation rate had fallen below 4 percent, and the stock market embarked on one of the longest and strongest bull markets in history.

For some people, the cure was worse than the disease. But most people who remember that period — including current members of the Fed — figure that a little preventive medicine now is a lot better then trying to deal with a full-blown inflationary spiral later.

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