The Fed and mortgages: different species, life spans

4 min read

The Federal Reserve cut the target for the federal funds rate by a quarter-point this week, and you can be sure of what that means for mortgage rates: They will climb. Or they will drop. Or they will stay about the same.

In other words, there isn’t a straight connection between what the Fed does and what fixed-rate mortgages do. Sometimes they move in the same direction and sometimes they move in opposite directions. Often, it depends on your time frame.

Some potential borrowers float their rate in advance of a Fed rate cut, expecting long-term, fixed mortgage rates to fall a quarter-point immediately after the Fed cuts a quarter-point. “They do not understand that it does not work that way,” says Kevin Weaver, a broker with Kash Mortgage in Lexington, Ky.

Weaver points out that the Fed cut the federal funds rate by a half-point Sept. 18 and a quarter-point on Halloween, and on both occasions long-term bond yields immediately jumped higher. Some mortgage lenders raised rates immediately, too.

After the Sept. 18 Fed rate cut, mortgage rates remained higher for a month before settling back down to where they had been before the central bank’s action. When the federal funds rate was cut Oct. 31, long-term bond yields spiked higher, then fell back the next morning.

Mayflies and parrots
A look at recent history shows that you can’t make solid, short-term predictions about what will happen to mortgages after the Fed cuts the federal funds rate. From Jan. 3, 2001, to June 30, 2003, the Fed reduced the federal funds rate 13 times. When you look about a month after each of those Fed cuts to see what happened to 30-year, fixed-rate mortgages, here’s what you find: Mortgages fell eight times and rose five times.

When you ignore the weekly peaks and valleys, the overall trend was the same: Mortgage rates fell. But when deciding whether to lock a rate or float, mortgage borrowers don’t much care what the overall, long-term trend is. They’re trying to predict what will happen to rates in the next month or so. The bottom line is that you can’t count on a drop in mortgage rates just because the central bank cut the federal funds rate.

This goes to show that the federal funds rate and the 30-year fixed mortgage rate are as different as mayflies and parrots. The latter pair have something in common — both have wings — but mayflies are insects that live just a few days; parrots are birds that live a long time. The federal funds rate and fixed-rate mortgages belong to different families and have different life spans, too. The federal funds rate is set by the government and is for overnight loans; fixed mortgage rates are set by the market and are designed for loans of 30 years or even more.

Multiple influences
Mortgage rates respond to changes in economic growth, wages, employment, oil prices, factory utilization and a host of other factors. The federal funds rate is minor. “There are so many other moving parts,” says Mark Fleming, chief economist for First American CoreLogic.

The economy has more moving parts than a belly dancer. And you can’t isolate one thing. Take, for example, the federal funds rate. By reducing it, the Fed runs the risk of reducing the dollar’s value on world markets. That makes imports more expensive.

Recent record-high prices for crude oil “are in part due to the weak dollar, because others on international markets are finding oil is typically bought in dollar denominations, and their money goes further,” Fleming says. “So they’re actually snapping up inventories because it’s more affordable to them, so a reduction in interest rates could further pressure oil prices.”

Shorter version: The lower federal funds rate could spell higher prices at the gas pump.

If higher fuel prices lead to higher prices for products that are shipped long distances — food, cars, televisions, toys and all the stuff we buy that’s made in China — that’s inflation, and higher inflation means higher mortgage rates.

Skyrocket back to earth
Fleming points out that the Fed didn’t drop just the federal funds rate. It also lowered the discount rate, which is what the Fed charges banks for short-term loans. The discount rate “is the mechanism they’re using to try to add more liquidity to the credit markets,” Fleming says — and a logjam in credit markets is partly what’s keeping jumbo mortgage rates so high.

A jumbo mortgage is a home loan for more than the conforming limit, which is $417,000 this year. Historically, jumbo rates are about a quarter of a percentage point higher than conforming rates, but for the last couple of months, the difference has been about three-quarters of a percentage point. The Fed seems to be trying to narrow that difference.

The problem with jumbos is a legacy of the boom years, when the Fed cut the federal funds rate to 1 percent and mortgage rates lingered below 6 percent. Money was cheap to borrow, so house prices skyrocketed. Homebuyers, fearful of getting priced out, got exotic mortgages. A lot of those loans blew up.

Alan Greenspan, chairman of the Fed during the housing boom, “owes the U.S. an apology for letting the mortgage market get so out of control, particularly when he saw housing prices skyrocketing,” says Anthony Sanders, professor of finance and real estate at Arizona State University.

Expect Greenspan’s successor, Ben Bernanke, to learn from the housing boom and crash. Many observers believe that the Fed is finished with cutting rates — unless the central bank sees unmistakable signs of a recession.