How does the Federal Reserve raising rates affect Mortgage Rates? The answer may surprise you.
The Federal Reserve just raised their target fed funds rate by 75 basis points, yet, at the same time, mortgage rates dropped a ton. So what gives?
I get this question - and more often a statement - all the time. The misconception is that the federal reserve "increasing rates" causes mortgage rates to immediately increase. That is not the case, and as you'll see it can actually have the opposite effect. So let me walk you through it.
What is the Fed - and why do they raise the Fed Funds Rate?
The Federal Reserve's job primarily is to maintain the stability of the financial system. (yeah - doing great, guys...) In the context of this post - one of their main goals is to keep inflation under control. Inflation is - as many people now know - a situation where the costs of goods and services increase over time. The dollar in your pocket doesn't buy as much food, gas, etc. When the government says that inflation is at 9.1%, that means that they are saying your dollar buys 9.1% less goods and services.
So, what causes inflation? A lot of things - but let's think of it as a lot of money chasing the same amount of goods. If you have 10 people (a lot of money) bidding on one iPhone - the cost of that phone will go up. But - if you have 10 iPhones and only one bidder (less money chasing more goods) the cost will go down (deflation).
So what the federal reserve is trying to do is control inflation by decreasing the amount of money chasing goods. The PRIME rate is used in many business and consumer loans. Home Equity Lines, Business Lines, etc. The Prime Rate is directly linked to the Fed Funds Rate - as the Prime rate is equal to the Fed Funds rate plus 3%.
So - the idea is - when the Federal Reserve raises the Fed Funds Rate - it makes borrowing more expensive, leaving less room for spending - and therefore less money chases the same amount of goods, and inflation drops. At least that's the idea.
So what does this have to do with Mortgage Rates?
The Fed Funds rate is not directly connected to long-term Mortgage Rates at all. Mortgage Rates fluctuate based on MORTGAGE BONDS. Basically, when Mortgage Bond Prices go up - Rates go down. When Mortgage Bond Prices go down - Rates go up...
Take a look at this chart:
Each of the "candlesticks" represented in green and red represent a trading day. Over the last several months, the trend has been downward - which pushed rates up. However, in the middle of June, and more recently into July on the chart - there has been a reversal, and rates have started to go down - because these bonds have started to go up in price.
So what causes these bonds to fluctuate in price?
Good question. In order to understand why rates go up and down, you need to understand why bonds go up and down. And - it probably won't surprise you that one of the KEY factors that affect bond prices is - you guessed it - Inflation.
Think about it. A bond is just a fixed income stream. Let's say you buy a bond that puts 100 dollars in your pocket each month. In a vacuum, that 100 dollars is 100 dollars, and that's great. BUT - when inflation creeps in, that 100 dollars is the same, but the amount of goods and services that you can purchase with it drops.
So if inflation looks tame - bonds look like a good investment, and their prices increase. But - with inflation raging, the value of bonds are whittled away and their prices drop.
Connecting the dots.
So why is it that the Federal Reserve "raised rates" and mortgage rates decreased?
Because Mortgage Rates are not based on the Fed Funds rate - they are based on bonds. When inflation is high, bonds drop and rates go up. The Fed increased rates in order to control inflation and the market saw that as something that would reduce inflation over time - so bonds went up, and rates came down.
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