Lower mortgage rates is a common misconception that is perpetuated by the mainstream media when the Fed makes an announcement of lowering rates.
However, when the Fed cuts interest rates, mortgage rates can actually increase.
According to Wikipedia:
The Federal Reserve System (also known as the Federal Reserve, and informally as the Fed) is the central banking system of the United States.
This system was conceived by several of the world’s leading bankers in 1910 and enacted in 1913, with the passing of the Federal Reserve Act. The passing of the Federal Reserve Act was largely a response to prior financial panics and bank runs, the most severe of which being the Panic of 1907.
Over time, the roles and responsibilities of the Federal Reserve System have expanded and its structure has evolved. Events such as the Great Depression were some of the major factors leading to changes in the system.
Its duties today, according to official Federal Reserve documentation, fall into four general areas:
- Conducting the nation’s monetary policy by influencing monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates.
- Supervising and regulating banking institutions to ensure the safety and soundness of the nation’s banking and financial system, and protect the credit rights of consumers.
- Maintaining stability of the financial system and containing systemic risk that may arise in financial markets.
The Federal Reserve controls two key interest rates in this country:
These are overnight lending rates used by banks when they lend money to each other.
When these rates are low, money is cheaper for banks to borrow, and that “cheap” money spreads throughout the economy.
The aim of the Federal Reserve in its interest rate policy is to either speed up or slow down the economy. In times of economic downturn, the Federal Reserve will cut rates to help create a boost. Conversely, in times of heavy inflation, the Fed will raise rates to help slow down the economy.
That’s it; speed up or slow down….no tricks.
When the credit crisis began to spiral in 2007, the Fed cut rates dramatically in hopes of jump-starting the economy. The Fed keeping rates near zero is an indication that the economy is moving along at a steady pace. If the economy improves to the point where inflation starts to creep up the Fed will begin hiking rates.
The Fed and Mortgage Rates:
Mortgage rates are tied to mortgage bonds, which are traded every day on the secondary market just like stocks.
Bonds are often considered a safer investment than stocks since they yield a constant rate of return.
During times of market turmoil, investors sell their stock holdings and move into bonds (called a “flight to safety” in financial jargon).
Conversely, when the economy is booming, investors move their money away from bonds and into stocks to take advantage of the upswing in the economy.
Remember, The Fed cuts interest rates to boost the economy.
When investors see this boost, they sell their bond holdings and move into stocks.
This movement causes the rates on those bonds to increase naturally as the bonds have to attract new investors with higher rates of return.
As a result, we see mortgage rates increase.
So, the next time you hear the Fed cutting interest rates, don’t assume mortgage rates will simply follow suit. The rate cut is simply meant to boost the economy, which moves money from bonds to stocks, and causes mortgage rates to rise.