Federal Reserve And Mortgage Interest Rates

Federal Reserve And Mortgage Interest Rates

Federal Reserve And Mortgage Interest Rates

Federal Reserve And Mortgage Interest Rates – Have you ever wondered why mortgage interest rates sometimes don’t go up when the Federal Reserve raises interest rates and vice versa? The simple answer is this: The Fed does not control mortgage interest rates.

Instead, the Federal Reserve controls the federal funds rate, which is the overnight interbank lending rate. The overnight rate is the shortest term of the loan. Short-term borrowing rates affect credit card interest and short-term auto loan interest. Not so much longer-term mortgage rates.

Federal Reserve And Mortgage Interest Rates

Federal Reserve And Mortgage Interest Rates

The Federal Reserve controls the federal funds rate. The federal funds rate is the interest rate that everyone refers to when debating whether to cut or raise interest rates. The federal funds rate is the interest rate at which banks lend to each other, not to you or me.

Things To Do Now, After The Fed’s Biggest Interest Rate Hike In Almost 30 Years

There is usually a minimum required reserve ratio that a bank must maintain with the Federal Reserve or in its bank vaults, eg 10% of all deposits must be held in reserves. Banks need a minimum amount of reserves to operate. This is similar to how we require a minimum balance in our checking accounts to pay bills. At the same time, banks seek to profit by lending as much money as possible for the spread.

If a bank has a surplus over its required reserve ratio, it can lend money at the effective federal funds rate to other losing banks and vice versa. A lower effective Fed funds rate encourages much more interbank borrowing to re-lend to consumers and businesses and helps maintain liquidity in the economy.

That’s exactly what the Federal Reserve was hoping for after it started cutting interest rates in September 2007 when housing prices began to fall.

In the summer of 2008, everyone was scared because Bear Sterns was sold for a pittance to JP Morgan Chase. And then on September 15, 2008, Lehman Brothers filed for bankruptcy. No one expected the government to let Lehman Brothers fail. When they did, that’s when the real panic started.

What Are Interest Rates & How Does Interest Work?

What happens when everyone panics? Banks stop lending and people stop borrowing! This is what we economists call a “crisis of confidence”. The Federal Reserve lowered the federal funds rate to force banks to keep funds flowing. Think of the Federal Reserve as pumping oil through a dying car engine.

Due to the fear of a new recession in 2020, mainly due to the coronavirus, the Federal Reserve cut interest rates by 50 basis points in March. With the 10-year bond yield well below 1% and a fed funds rate range of 1.25%-1.5%, it is clear that the Federal Reserve will need to taper again.

The Federal Reserve’s main goals are to keep inflation under control (target CPI of 2%) while keeping the unemployment rate as close as possible to the natural rate of employment (3% – 5%).

Federal Reserve And Mortgage Interest Rates

The Federal Reserve does this through monetary policy – ​​raising and lowering interest rates, printing money, or buying bonds to inject liquidity into the system. After the financial crisis, they did a commendable job. However, if the Federal Reserve keeps interest rates low for too long, inflationary pressures could increase due to too much economic activity.

How Do Federal Reserve Decisions Impact Mortgage Rates?

Why is inflation bad? Inflation is not bad if it moves at a constant annual rate of 2%. Things get out of hand only when inflation starts to climb to 5%, 10%, 50%, 100% and more. In such a scenario, you may not earn enough to buy future assets or your savings may lose purchasing power at too fast a rate. Or you just can’t properly plan your financial future.

The only people who like inflation are those who own real assets that inflate with inflation. These assets typically include stocks, real estate, and owners of health care, child care, senior care, and higher education companies! Everyone is a price-setter who is pressured by higher rents, higher tuition, higher food, higher transportation, etc.

In boom times, when employers are aggressively hiring and wage growth outpaces CPI, the Federal Reserve may need to raise interest rates before inflation gets out of hand.

By the time inflation hits us in the face, it may be too late for the Fed to be effective, as there is usually a 3-6 month lag in the effectiveness of monetary policy.

The Federal Reserve Dropped The Prime Rate Again. What Does This Mean To You?

Higher interest rates slow the demand for borrowing money, which in turn slows the pace of production, job growth and investment. As a result, the inflation rate will eventually decrease.

If the Federal Reserve could make an inflation figure of 2% and an unemployment figure of 3.5% forever, they would take it. Alas, the economy still ebbs and flows.

Today we have negative real mortgage rates, which is huge for the real estate industry. More people will borrow more money. And since the real interest rate is negative, it’s like being paid to borrow money!

Federal Reserve And Mortgage Interest Rates

As a result, the real estate market should remain strong for years to come. I wouldn’t want to rent after the pandemic. Rents and property prices will continue to rise.

Will Rising Mortgage Rates Put An End To The Housing Recovery?

The Federal Reserve sets the Fed funds rate. The Federal Reserve does not set mortgage rates. Instead, the bond market determines the 10-year bond yield. And the 10-year bond yield is the dominant factor in determining mortgage rates.

There is definitely a correlation between the short-term fed funds rate and the longer-term 10-year yield, as you can see in the chart below.

The first thing you’ll notice is that the federal funds rate (red) and the 10-year Treasury yield (blue) have declined over the past 40 years. There have certainly been times when both rates have risen between 2% and 4% in a five-year window. However, there is a strong downward trend due to knowledge, productivity, coordination and technology.

This long-term downward trend is one of the main reasons why taking out a 30-year fixed-rate mortgage instead of an adjustable-rate mortgage will likely cost you more money than you need.

Federal Reserve Will Begin Tapering: What Does That Mean For Mortgage Interest Rates?

1) From 1987 to 1988, the Fed raised rates from 6% to 10%. From 1994 to 1996, the Fed raised rates from 3% to 6%. From 2004 to 2007, the Fed raised rates from 1.5% to 5%. In other words, the Fed is unlikely to raise the fed funds rate by more than 4% in the future.

2) The Fed has run out of ammunition to cut rates. During the last two recessions, the Fed would be willing to cut rates by as much as 5% to help stimulate the economy. With an effective Fed funds rate of 1.25%-1.5% in the first quarter of 2020, the Fed may no longer be able to exert as much influence.

3) The longest cycle of interest rate increases or decreases is about three years after the Fed starts raising or lowering rates.

Federal Reserve And Mortgage Interest Rates

4) The 10-year yield does not fall or rise as much as the Fed funds rate. In this article I explain why.

Fed’s Interest Rate History: The Fed Funds Rate Since 1981

5) The S&P 500 has generally moved up and to the right since its inception. The increase corresponds to a decline in both interest rates since the 1980s.

5) The average spread between the federal funds rate and the 10-year bond yield has been over 2% since the 2008-2009 financial crisis. However, the gap has now aggressively reversed in 2020. This indicated a recession.

Look at what happened between 2004 and 2010. The difference between the 10-year rate and the funds rate was about 2%. The Fed then raised the Fed funds rate from 1.5% to 5% until the housing bubble it helped create burst.

The Fed funds rate and the 10-year rate reached parity at 5%. Maybe if the Fed had just raised the Fed Funds rate to 3% to maintain an average margin of 2%, the economy wouldn’t have collapsed like that.

The Fed Just Cut Rates. Should Your Refinance Your Mortgage

Below is a close-up of the S&P 500, the Fed Funds rate and the 10-year bond yield.

The difference between the 10-year rate and the Fed funds rate has averaged more than 2% since the financial crisis

Now that you have a solid understanding of interest rates, you can see how pointless it is when someone tells you to buy real estate before interest rates (meaning the Fed) go up and vice versa.

Federal Reserve And Mortgage Interest Rates

The federal funds rate could easily raise rates while the yield on the 10-year note may not change. Who is usually right? The seven Boards of Governors of the Federal Reserve or the bond market worth more than 100 trillion dollars with thousands of domestic and international investors?

How Higher Mortgage Rates Have Historically Affected Home Prices

Of course, the market knows best. The Federal Reserve has consistently shown policy errors in the past. They raised rates when they shouldn’t have. Or they made a surprise cut when they shouldn’t have. They either kept rates too low for too long or kept rates too high for too long.

Because the United States is considered the most sovereign country in the world, our assets are also considered the most stable. As a result, China, India, Japan and Europe are big buyers of US Treasuries. Because of this, their financial destinies are intertwined with ours.

Let’s say that China and Japan are going through hard landing scenarios. International investors will sell Chinese products and

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