Fed Rate Cuts Don’t Necessarily Mean Lower Mortgage Rates

So the Fed cuts rates another 0.75%. Is a Fed rate cut really good news for mortgage rates? The facts may be surprising. The Federal Reserve can only control the Fed Funds Rate and the Discount Rate. The Fed Funds Rate is the rate at which banks can borrow money from one another on an overnight basis. The Discount Rate, on the other hand, is the rate at which banks can borrow money directly from the Fed on an overnight basis (now a 30 day basis). This is very different from mortgage rates.

A mortgage rate can be in effect for 30 years. A rate that is set by the Fed can change from one day to another. This is a counter-intuitive relationship for most people because when they hear that the Fed is lowering rates, they instinctively think it means mortgage rates.

The Federal Reserve uses the Fed Funds Rate and the Discount Rate to both stimulate and slow down the economy. The Fed watches trends in new jobs, new unemployment filings, worker productivity, wages, housing, both resale and new construction, and inflation at the consumer and producer level.

The Federal Reserve is trying to maintain a “healthy” economy. If the economy is growing too fast the Fed will raise rates to slow down economic growth. If the economy is slowing down, as it is currently, the Fed will cut rates, and sometimes aggressively, in an attempt to stimulate economic growth.

So what are mortgage rates based on? The answer is mortgage-backed bonds known as Mortgage-Backed Securities (MBS). How these bonds issued by Fannie Mae and Freddie Mac perform will determine the direction of mortgage rates.

It is not necessarily what the Fed does that affects mortgage rates, it’s how the Nasdaq and the broader stock market interprets the Fed’s action and policy statement that will ultimately influence the direction of mortgage rates. This is because money managers and mutual fund companies typically keep funds in either stocks or bonds with very little in cash. If stocks are in favor, money is pulled from bonds, causing bond prices to drop and interest rates to rise. When stocks are being sold off, the money is then parked into bonds, which improves bond prices and causes interest rates to decline.

If the Fed Funds Rate and mortgage rates were truly related, the chart shown here wouldn’t show them going in opposite directions – all three lines would move in tandem.

Fed rate cuts can fuel inflation, because lower rates just serve to make it more attractive to buy and finance goods and services. If the economy grows too fast, as has been the case for the last five or so years, inflation can become a problem for the consumer (you and me).

The Federal Reserve is doing all it can to keep this country from going into a recession. While the Fed normally seeks a balance between economic growth and inflation, in this case the Fed has essentially decided to sacrifice inflation to save the economy. That is not to say that the Fed is turning a blind eye to inflation. They are just focusing more attention on keeping the economy from slipping into a recession. There is a concern about the possibility of Stagflation. Those who remember Nixon remember Stagflation. This is a situation where the economy stalls and inflation rises simultaneously. In other words, people are losing jobs, making less money, and spending more to buy the basic necessities of life because of inflation.

I wouldn’t want to be Ben Bernanke is these trying times. To summarize, Fed rate cuts do not necessarily equal lower mortgage rates. There are a variety of factors that influence mortgage rates and it is important for people to know that so they don't wait for the next Fed rate cut to refinance or purchase and miss the boat because what they thought to be true turned out not to be.