How the Fed, mortgage rates and Bin Laden are connected
By Holden Lewis • Bankrate.com

The Federal Reserve cut short-term interest rates by a quarter-point on Tuesday. When that happens, people start calling and visiting mortgage offices.

"They say, 'Well, I guess mortgage rates are going down, '" says Jim Bradley, president of American Residential Lending Corp. in Atlanta. "What they hear is that the Fed has cut interest rates," Bradley adds. "To them, that means mortgages, car loans and everything."

That's when Bradley has to explain that mortgage rates don't necessarily fall when the Fed cuts short-term interest rates. Sometimes they do; sometimes they don't. In fact, mortgage rates act independently of the short-term interest rates controlled by the Fed.

Exhibit A is what happened with mortgage rates this week. Rates climbed for a few days as investors responded to hopeful economic news. Then they fell for a few days when it became clear that the Fed didn't believe that an economic recovery was around the corner. But rates went up more than they went down.

As a result, the benchmark 30-year fixed-rate mortgage rose 19 basis points to 7.11 percent, according to the Bankrate.com national survey of large lenders. A basis point is one-hundredth of 1 percentage point. The mortgages in this week's survey had an average total of 0.62 discount and origination points.

It looks like mortgage rates bottomed out in early November. (Graph the trend)

After that, investors started paying attention to every scrap of encouraging economic news: higher-than-expected retail sales (driven by zero-percent auto financing), rising consumer confidence, a decline in the rate of layoffs.

When it looks like the economy is about to recover from a recession, investors expect inflation to follow. So they bid up the price of long-term interest rates, even as the Fed fights the recession by lowering short-term rates.

"What becomes important is the inflationary expectations of investors who are effectively lending long-term," says Frank Nothaft, chief economist for Freddie Mac.

With the Fed's quarter-point rate cut this week, "does my view about inflation over the next 10 years really change? Most investors will say no," Nothaft says. That's why a drop in short-term rates doesn't cause long-term rates to fall.

Although the Fed's rate cut has little impact on long-term mortgages, it does affect adjustable-rate mortgages -- especially one-year ARMs, which are adjusted annually and often are tied to the prime rate. Since the prime rate dropped from 5 percent to 4.75 percent in response to the Fed rate cut, many one-year ARMs will drop, too.

The bond traders and investors who set mortgage rates pay attention to more than economic news. They keep tabs on what's happening worldwide.

"If Bin Laden is caught or blown to bits, there's going to be a sigh of relief," Bradley says. "People will be more comfortable about their next purchase, and interest rates will pick up."

This is as good a place as any to explain how Bankrate.com's weekly mortgage survey is done and what it means. Every Wednesday, Bankrate.com researchers query the same 100 lenders -- the 10 biggest lenders in the 10 biggest U.S. markets -- about the mortgage rates they're offering that day. Bankrate.com's benchmark survey is the average of those rates.

Here are a few things to keep in mind: The rates quoted are for people with good or excellent credit who make at least a 20-percent down payment to buy a single-family residence in good repair. Bankrate.com asks for rates with no or low points.

The weekly survey makes for an accurate historical record of rates in the nation's biggest markets, and it shows which direction rates are heading from week to week.

At volatile times like now, when mortgage rates jump up and down from day to day, the survey could be outdated in just a day or two. Also, many lenders and brokers can offer better rates than the big banks in the big cities.

For those reasons, it's best to use the Bankrate.com weekly mortgage survey as a general guide that tells you roughly where mortgage rates are and in which direction they're headed.