On October 31, 2007, the Federal Reserve Board lowered the federal funds rate by 25 basis points, to 4.5%. For mortgage shoppers, the natural question was whether this Fed rate cut would give them a Halloween treat in the form of lower mortgage rates.

 The bad news is that the federal funds rate does not directly affect mortgage rates. The good news is that the federal funds rate and mortgage rates are influenced by many of the same economic forces, and mortgage rates had already started trending downward before the Fed rate cut.

 Anatomy of an Interest Rate

The federal funds rate and mortgage rates are both interest rates charged for certain types of loans. When money is lent, there are three primary factors which determine the rate of interest that is charged on the loan:

      1.The expected rate of inflation

      2. Duration--essentially, the length of the loan.

      3. Creditworthiness--how likely the borrower is to make principal and interest payments.

 Where Federal Funds Rate and Mortgages Differ

Significantly, two of those three components of interest rates are very different for the federal funds rate than they are for mortgages. The federal funds rate represents interest on very short-term, very high-quality loans. Mortgage rates are underwritten for much longer terms, and carry more risk of default. Both are reasons why mortgage rates are higher than the federal funds rate, and why the two do not move in lockstep with one another.

 Common Ground--the Outlook for Inflation

Inflation is the common ground between the federal funds rate and mortgage rates. Inflation is a complex subject, but in general, when economic growth is seen as heating up, the concern is that rising demand will boost inflation. When economic growth is thought to be slowing, inflation pressures tend to ease.

 This is why interest rates have a tendency to rise when the outlook for economic growth is strong, and they fall when a slowdown is feared.

 The Responsiveness of Markets

Both the Federal Reserve and the mortgage market see signs that economic growth is slowing. Since mortgage rates are set freely in an open market they can respond more immediately. This is why mortgage rates started trending downward in August, ahead of the Fed rate cuts in September and October.

 Indeed, if you are looking for an indicator for the direction of mortgage rates, the bond market may be a better source than the federal funds rate. Tellingly, 30-year Treasury bonds rates started trending downward in July--ahead of mortgage rates, and well ahead of the subsequent Fed rate cuts.

 The Federal Reserve, the mortgage market, and the bond market all are very sensitive to inflation. As a result, they tend to be influenced by the same indicators, though the mortgage and bond markets can react more fluidly. Therefore, if you want a more immediate gauge of where interest rates are headed, don't watch the Fed--watch what the Fed is watching.  

This brings us back to the good news. The October 31st Fed rate cut simply followed a trend already evident in the mortgage market. In other words, because of the responsiveness of this market, mortgage shoppers got their Halloween treats a little early.

Source:

The Federal Reserve