Why Fed Rate Cuts do not lower mortgage rates by Evan Swanson, CMPS
The Fed is at it once again slashing short-term interest rates with the hopes of helping the economy avoid a steep recession. Many people, including so-called “experts” in the media, believe the recent Fed cuts are the reason why mortgage rates touched 4-year lows on January 22nd. However, if you look at history the results may surprise you.
Let’s first remember that the Federal Reserve can only control the Discount Rate and Fed Funds Rate. These are short-term rates used for overnight lending between banks and can change from day to day. This is very different than 30 year mortgage rates which remain fixed for a much longer period.
The last time the Fed went on a lengthy rate cutting cycle was back in 2001. In the span of 12 months (January- December) the Fed cut the Fed Funds Rate from 6.00% to 1.75%. To an uninformed consumer one would think that mortgage rates would have also decreased significantly over that timeframe. In fact, 30 year fixed rate mortgages actually increased from 6.95% in March to 7.07% in December (source: www.freddiemac.com).
In the most recent cycle, the Fed began cutting short-term interest rates on September 18th, 2007. From then until now the Fed has slashed short term interest rates from 8.25% down to 6.00%. Over that timeframe mortgage rates have come full circle starting at around 6.25%, falling as low as 5.00% in late January, and now back up to the 6.25% range in late February.
The truth is that fixed mortgage rates are wholly determined by the direction that mortgage-backed bonds trade. Mortgage-backed bonds are bonds which are sold to investors that are backed by the mortgages that you and I pay interest on. When the demand for these assets increase it drives up the price and lowers the yield. This is what causes mortgage rates to decrease and vice versa.
So, what is it that causes the prices of these assets to fluctuate? Like other asset classes such as stocks, there are many factors that we can identify. However, the primary factor is inflation expectations. If you think about it this makes sense. If you’re going to lend another person some money today and you expect the purchasing power of that money to be significantly less in the future, due to inflation, then you will charge them a higher rate of interest in order to borrow your money.
This is exactly the case for mortgage rates. When inflation expectations increase so do mortgage rates and vice versa. So when do inflation expectations rise or fall? Again, there are a myriad of factors that can influence inflation expectations including commodity prices, the economic outlook, and inflation data.
However, I would argue that mortgage rates recently touched 4-year lows not because of the Fed’s rate cut but because of the fear and concern that the Fed raised when they made their surprise .75% on the morning of January 22nd.
For now investors are beginning to realize that the implication of the “easy-money” monetary policy combined with the generous fiscal stimulus package is likely to be increased inflation.
Posted: February 26th, 2008 under Economics & Interest Rates, General Mortgage Info., Rate Update, The Fed.
Tags: Fed, Monetary policy
Comments
Pingback from My Mind on Mortgages » Rate Update October 27, 2008
Time October 27, 2008 at 7:40 am
[...] This week the Fed is scheduled to announce their interest rate decision on Wednesday. The markets are expecting a .50% cut but some analysts believe a .75% cut is likely. Please remember that a cut to short-term rates DOES NOT necessarily translate into lower mortgage rates. [...]
Pingback from My Mind on Mortgages » Rate Update October 29, 2008- Fed Day
Time October 29, 2008 at 7:47 am
[...] Today all eyes are on the Fed. They will announce their interest rate decision at 2:15 EST. Watch today’s you tube video for more information regarding this announcement. Let us remember that a cut to the Federal Funds rat DOES NOT necessarily mean that mortgage rates wi…. [...]
Pingback from My Mind on Mortgages » Rate Update October 30, 2008
Time October 30, 2008 at 7:35 am
[...] As expected the Fed did cut short-term interest rates yesterday by .50%. This takes the Federal Funds Rate down to 1.00% and the Prime rate to 4.00%, the lowest levels since the “post-9/11 Greenspan Era”. As a reminder, a cut to short-term interest rates DOES NOT necessarily cause mortgage rates to drop. [...]
Pingback from My Mind on Mortgages » Fed rate cut and mortgage rates
Time December 15, 2008 at 7:19 am
[...] I thought it appropriate to re-post the article I wrote back in February entitled, “Why Fed Cuts Do Not Lower Mortgage Rates“. [...]
Pingback from My Mind on Mortgages » Rate Update December 16, 2008
Time December 16, 2008 at 9:21 am
[...] today. It is widely expected that they will cut short term rates by .50%. In and of itself their cutting rates WILL NOT directly impact mortgage rates. In fact, by cutting rates to less than 1.0% the Fed will put pressure on the US Dollar which [...]
Pingback from My Mind on Mortgages » Rate Update December 17th 2008
Time December 17, 2008 at 8:58 am
[...] latest surge in lower interest rates? Yesterday after the Fed lowered the Fed Funds Rate by .75%, which typically would be a nemesis to mortgage rates, they went on to state that they would buy as much as $600 Billion of debt secured by Fannie Mae, [...]
Pingback from My Mind on Mortgages » Rate Update November 3, 2009
Time November 3, 2009 at 7:32 am
[...] One catalyst that could cause this shift is the Fed. Speaking of whom they begin day one of their two day monetary policy meeting today. It will conclude tomorrow with their monetary policy announcement and statement. It is widely expected that the Fed will leave short-term rates unchanged. However, some analysts expect that they will shift the wording in their statement to reflect the increased likelihood of rates hikes in the next 6-12 months. This could put selling pressure on the bond market because it would be viewed as inflationary in nature (otherwise, why would the Fed raise rates?). [...]
Pingback from My Mind on Mortgages » Rate Update January 27, 2010
Time January 27, 2010 at 7:47 am
[...] their 2-day monetary policy meeting and are widely expected to leave short-term rates unchanged (click here to understand why this doesn’t really matter). More importantly than their rate decision, [...]
Pingback from My Mind on Mortgages » Rate Update March 16, 2010
Time March 16, 2010 at 7:41 am
[...] this morning as we await the Fed’s policy statement later on. Let’s not forget that the Fed does not directly set mortgage rates. However, the Fed’s monetary policy which directs short-term [...]
Pingback from My Mind on Mortgages » Rate Update October 7, 2008
Time October 7, 2008 at 7:59 am
[...] cut to the Federal Funds rate prior to their October 29th meeting. I want to remind readers that a cut to short-term rates DOES NOT mean mortgage rates will automatically dip as well. However, the emotional response to the fact that the fed is making another [...]