The words “interest rates” and “bizarre” rarely occupy the same sentence, but they belong together now. Interest rates have behaved bizarrely in the last few months, so it’s tricky to predict what the Federal Reserve will do next.

The Fed’s rate-setting committee increased the target federal funds rate a quarter point on Sept. 21, to 1.75 percent. The prime rate will rise to 4.75 percent. Consumer loans based upon the prime rate — chiefly variable-rate credit cards, home equity lines of credit and auto loans — can be expected to rise about a quarter point.

The rate-setting committee issued a statement that said rates remain “accommodative”
in other words, low
and are helping the economy.

“With underlying inflation expected to be relatively low, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured,” the statement read, implying that the panel will continue to raise rates gradually in the future.

The increase came as no surprise, as Fed officials had been dropping hints. Investors and economists expect at least one more rate hike, but aren’t sure when it will happen.

The Fed’s rate-setting body — the Federal Open Market Committee — has two more meetings scheduled this year, Nov. 10 and Dec. 14. Most economists believe that the Fed wants to raise the federal funds rate to 2 percent at least, but the timing depends on the economy’s health in the coming months. Lately, the prognosis hasn’t been very good, if you look at what’s been happening to interest rates.

Stubbornly, mortgages remain a bargain
Short-term rates have been going up while long-term rates, such as fixed-rate mortgages, have been going down. That’s not what the Fed intended in late June when it raised the federal funds rate for the first time in four years. Everyone expected interest rates to rise across the board. That didn’t happen. In the lingo of economists, the yield curve flattened: Short-term rates rose and long-term rates fell. It flattened rapidly, which is a sign of a slowing economy.

“The flattening of the yield curve is bizarre and unprecedented,” says Bill Hummer, economist for Wayne Hummer Asset Management in Chicago. “It’s derived from the fact that policy is tightening even as the economy is slowing. That’s a rare sequence of events.”

It’s rare because the Fed normally raises short-term rates to slow a fast-growing economy and reduce inflation — like applying the brakes on a bicycle that’s zooming down a steep hill. But now, the Fed is raising short-term rates while the economy is growing only moderately, with little sign of inflation. That’s like applying the brakes on a bike that’s coasting on level ground.

Whacking the inflation mole
By increasing short-term rates on an economy whose rate of growth is slowing, the Fed is smacking inflation on the nose almost before it can stick its head out of its hole — like a master at the Whack-a-Mole machine.

Long-term rates respond to investors’ expectations of inflation. With short-term rates on the rise, investors become less concerned about inflation, and long-term rates fall.

Hummer looks to the end of April, when the federal funds rate was 1 percent, the yield on the 10-year Treasury note was 4.53 percent and the average rate on a 30-year fixed mortgage was 6.07 percent. Now the federal funds rate is 1.75 percent, the yield on the 10-year Treasury is 4.07 percent and the average rate on a 30-year mortgage is 5.76 percent. Short-term rates rose 75 percent, but long-term mortgage rates and Treasury yields declined.

The trends aren’t always consistent. Since the end of April, the average yield on a one-year certificate of deposit has increased from 1.19 percent to 1.66 percent, while the average yield on a longer-term five-year CD has gone up, too, from 3.13 percent to 3.56 percent. At the same time, the yield on the five-year Treasury note fell 7 basis points.

One more bump or two?
The Fed didn’t intend to make long-term rates fall, but that’s what happened in most cases. The rate-setting committee clearly thinks short-term rates are too low and the Fed’s challenge is to raise rates without stalling the economy. That’s why there’s a lot of speculation that the Fed will raise rates at one, but not both, of its remaining two meetings in 2004.

The Fed wants to return to a neutral policy, in which rates are neither too high nor too low. “To get to a neutral policy, ideally you’d like the federal funds rate to be at or slightly higher than the rate of inflation,” says Larry Goldstone, president of Thornburg Mortgage of Santa Fe. With core inflation around 1.7 to 2 percent, that means another Fed rate increase, to 2 percent, in Goldstone’s estimation.

He believes that rates, overall, won’t move much for the rest of the year. That bodes well for home buyers, who should continue to find bargain rates when they shop for mortgages. The flatter yield curve means that adjustable-rate mortgages aren’t quite the bargain they were a few months ago, but ARMs “still have some advantage,” Goldstone says.