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If the Fed raises short term rates - what does it mean for mortgage rates?    

 

by Keith Luedeman, CEO   

News

06/23/2010 - Fed keeps rates stable, says exceptionally low Fed Funds rates are here for an extended period.   Information received since the Federal Open Market Committee met in April suggests that the economic recovery is proceeding and that the labor market is improving gradually. Household spending is increasing but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit. Business spending on equipment and software has risen significantly; however, investment in nonresidential structures continues to be weak and employers remain reluctant to add to payrolls. Housing starts remain at a depressed level. Financial conditions have become less supportive of economic growth on balance, largely reflecting developments abroad. Bank lending has continued to contract in recent months. Nonetheless, the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, although the pace of economic recovery is likely to be moderate for a time. Prices of energy and other commodities have declined somewhat in recent months, and underlying inflation has trended lower. With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to be subdued for some time.   Text of the full release here.   04/28/2010 - Fed keeps rates stable, says exceptionally low Fed Funds rates are here for an extended period.   Information received since the Federal Open Market Committee met in March suggests that economic activity has continued to strengthen and that the labor market is beginning to improve. Growth in household spending has picked up recently but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit. Business spending on equipment and software has risen significantly; however, investment in nonresidential structures is declining and employers remain reluctant to add to payrolls. Housing starts have edged up but remain at a depressed level. While bank lending continues to contract, financial market conditions remain supportive of economic growth. Although the pace of economic recovery is likely to be moderate for a time, the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability. With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to be subdued for some time.  In light of improved functioning of financial markets, the Federal Reserve has closed all but one of the special liquidity facilities that it created to support markets during the crisis. The only remaining such program, the Term Asset-Backed Securities Loan Facility, is scheduled to close on June 30 for loans backed by new-issue commercial mortgage-backed securities; it closed on March 31 for loans backed by all other types of collateral.   Text of the full release here. 03/16/2010 - Fed keeps rates stable, says exceptionally low Fed Funds rates are here for an extended period.   Information received since the Federal Open Market Committee met in January suggests that economic activity has continued to strengthen and that the labor market is stabilizing. Household spending is expanding at a moderate rate but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit. Business spending on equipment and software has risen significantly. However, investment in nonresidential structures is declining, housing starts have been flat at a depressed level, and employers remain reluctant to add to payrolls. While bank lending continues to contract, financial market conditions remain supportive of economic growth. Although the pace of economic recovery is likely to be moderate for a time, the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability.   With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to be subdued for some time.   The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period. To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve has been purchasing $1.25 trillion of agency mortgage-backed securities and about $175 billion of agency debt; those purchases are nearing completion, and the remaining transactions will be executed by the end of this month. The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to promote economic recovery and price stability.     Text of the full release here.   02/18/2010 - Fed raises rate banks pay for emergency loans, the Discount Rate.   The Federal Reserve said on Thursday it was raising the interest rate it charges banks for emergency loans, its first rate move since December 2008, but insisted borrowing costs for consumers or companies would not rise.  The increase in the spread and reduction in maximum maturity will encourage depository institutions to rely on private funding markets for short-term credit and to use the Federal Reserve's primary credit facility only as a backup source of funds. The Fed said the discount rate would be increased to 0.75 percent from 0.50 percent, effective Friday. It left its benchmark interest rate unchanged near zero - at .25%. "Like the closure of a number of extraordinary credit programs earlier this month, these changes are intended as a further normalization of the Federal Reserve's lending facilities," the Fed said in a statement.  "Like the closure of a number of extraordinary credit programs earlier this month, these changes are intended as a further normalization of the Federal Reserve's lending facilities. The modifications are not expected to lead to tighter financial conditions for households and businesses and do not signal any change in the outlook for the economy or for monetary policy, which remains about as it was at the January meeting of the Federal Open Market Committee (FOMC). At that meeting, the Committee left its target range for the federal funds rate at 0 to 1/4 percent and said it anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period."   Text of the full release here. Click here to review fed rate changes since 1990.  Click here to review prime rate changes.

 

The Federal Reserve met today to consider policy on short-term interest rates.  The Federal Reserve had cut two key short-term interest rates 11 times over the past few years to fight the recession. 

 

But they decided to raise the Discount rate during their most recent meeting, after keeping rates stable since December of 2008.  

The two short-term interest rates the Fed controls are the federal funds rate and the more symbolic discount rate.

The fed funds rate -- short for federal funds rate -- is the interest rate at which banks lend to each other overnight. The Fed sets this rate by buying or selling government securities until the target level is achieved. As such, it is a market interest rate.

The discount rate is the interest rate charged by a Federal Reserve Bank on short-term loans to depository institutions. The discount rate is important for two reasons: (1) it affects the cost of reserves borrowed from the Federal Reserve and (2) changes in the rate can be interpreted as an indicator of monetary policy.

 

These two rates do affect the economy and it's performance.  However, the rate cuts do take 4-6 months to work their way through the nation's economy.

Another rate influenced by, but not directly controlled by the Fed is Prime rate. This is the rate charged by commercial lenders on short-term loans to their lowest-risk, most creditworthy customers, such as large corporations. Often serves as a basis for rates on other loans.

 

Mortgages rates have been on the decline for the last few years - reaching their lowest levels in years.

 

The Fed's rate decisions affect mortgage rates setting the levels of 1 year adjustable rate mortgages and indirectly through the Fed's influence on longer-term rates that bond markets set.

 

We've had many people call us and ask - will mortgage rates go up when the Fed raises rates again?

 

The answer - it depends.    

 

Basically, short term rates are raised on the basis to slow economic growth and thus inflation.  If the rate cuts are successfully the economy begins to grow less rapidly, which decreases the demand for capital. As the demand for capital lessens, over time, the law of supply and demand ultimately pushes interest rates lower. 

Mortgage rates are often much longer-term financial instruments - not short term rates -  since mortgages can be over a term as long as 30 years.  But since most mortgages are paid off when people move or refinance and do not last 30 years, mortgage rates tend to closely follow the 10-year Bond yield.  The 10-year Bond yield is determined in the open market and do not always move in lockstep with short-term rates.  Fixed mortgage rates do not follow the variable short-term the fed funds or discount rate.   Shorter term ARMs usually do, but not the 15 and 30 year mortgages.

Long-term rates are sensitive to expectations about inflation. If short-term rates like the ones the Fed controls are going up, this is usually an indication that the economy is growing, and the increase in short term rates can discourage borrowing and spending, which can actually cause inflation to decrease. Long-term rates, such as mortgage rates, often fall when concerns about inflation decrease, but long term rates rise when there are concerns about too much economic growth and inflation.
  
The short term rates the Fed controls, and the long term bonds that affect mortgage rates, have a basic opposing effect.
 
Basically, short term rates are increased on the basis to decrease economic growth and prevent inflation.
 
Once rates are increased enough to decrease spending, economic growth decreases, inflation risk decreases, and three things happen to decrease long term bond rates, and thus mortgage rates. 

1) Businesses: Higher interest rates make it more difficult for businesses to get loans to expand. Unemployment tends to rise, which eases wage inflation, although at a human cost.  Demand for capital decreases, lowering the interest rate through the laws of supply and demand.

2) Markets: Higher interest rates tend to attract investment into bonds and other fixed-income investments, pushing down stock prices.  Investors pull out of the stock market and push into the bond market to seek safer yields. This increases the price on the bond, thus lowering the rates.  If they see the Fed not acting aggressively enough, then they do the opposite, raising rates

3) Consumers: Higher interest rates on credit cards and mortgages can cool consumer spending, which accounts for about two-thirds of economic activity.  Since there is less risk of inflation in the future since economic growth is not occurring as fast, the bond yield can be lower since it is safer than the stock market, and there is no risk of inflation overwhelming this return. 
 
Since the bond and stock market and Real Estate make up the majority of wealth in our country, when inflation rises to much, spending reduces, and once again the cycle starts again.

Early the cycle of rate increases, it's hard to tell if the market will view the fed as acting too slow, or too aggressively.

So it is a constant battle for the Fed between fighting inflation and economic growth.  The Fed tries to balance the equation so long term rates and inflation is low, and the economy growing at a solid pace.

This is exactly what happened before the recent fed meeting about the fed funds rate. Mortgage rates actually rose because of inflation concerns. Housing financial markets often are ahead of the Fed. Mortgage interest rates are determined every day in active public markets. If those markets believe the economy is growing too fast and causing inflation, and the market is concerned that the Fed is not acting fast enough to raise rates and control inflation, interest rates may increase as the markets anticipate inflation.
  
It’s almost impossible to accurately predict the future of something as complex as the U.S. economy. However, it is important that mortgage consumers understand some of the market dynamics. A lack of understanding can cost them money.

 

As bond prices rise, the yield, or effective interest rate, drops.  If bond prices are going down  (which means the yield or interest rate is going up) that is generally a sign that higher mortgage rates are ahead. A weak bond market will usually (but not always) cause mortgage rates to rise. (see also Bond Prices and Bond yields)

 

Bond yields (rates) are usually high during a strong economy where there is inflation risk, and lower when there is little inflation risk. 

 

The bond yield had been on the rise for the last several months, as the bond market feels that the economy is in good shape and growing at a steady and possibly inflationary pace.  For today's announcement, rates were down slightly.

 

Many anticipate that long term mortgage rates will fall if the Fed's action spark a decline in the stock market by slowing the economy, which will cause money to flow out of stocks and into bonds.  This would cause bond yields to lower, which causes long term mortgage rates to go down.  Adjustable Rate Mortgage (ARM) rates will go up.

 

There is a bright side to this picture. The increase in short term rates is a sign the economy is in good shape, and the increases now will keep long-term rates lower over time by preventing inflation.  

 

Consumers might want to consider an interest only payment mortgage instead of a 30 year fixed - even some of these products have a 30 year fixed rate.  Or locking in a lower mortgage rate for three or five years could make sense because most people do not stay in a home more than five years, and those who do could refinance later.

 

What's next?  Depends on if the bond market feels the economy is better than the fed thinks it is - or if the fed is too slow to raise the short term rates again.  If the economy slows, bond rates will fall.  For now, bond rates and mortgage rates are moving higher, the question is how much and for how long?  

 

Rates will rise for home equity lines if the fed increases rates.  Those are based on prime, and if banks increase prime rate from 3.25% - home equity lines and second mortgage rates will be higher.  

Also, rates for people with challenged credit will slowly fall, as the economy is improving and this is lowering the risk in an economic growth cycle.

 

The overall result - rates are still very low - it's a great time to refinance or buy a home.

 

Want more information on exactly how the fed rates changes affect the economy?

Click here for more details on effects of rate increases.
Click here for more details on effects of rate decreases.

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