Blog by John Lynch of PRG Funding
If I had a dollar for every person that said to me, “the Federal Reserve cut mortgage rates why are they higher than last month.” Contrary to popular myth, the Federal Reserve doesn't control mortgage rates. In fact, their most well-known strategic tool -- the Federal Funds rate -- is the overnight interest rate which banks charge each other when a bank needs to borrow money to meet end- of-day reserve requirements. Those are the rules that say that a bank must have so much cash on hand when the books close at the end of the day, and those funds can be borrowed from another bank at this interest rate. You should know that the Fed merely "suggests" what that rate should be, which is why it's called a "target" rate; the actual rate is negotiated between the borrower bank and the lender bank.
A good way to keep a handle on the Fed is to remember that the Fed Funds rate is the shortest of short-term rates – almost like an overnight loan -- and a fixed-rate mortgage is all the way at the other end of the scale, a loan that lasts as long as 30 years.
The end result is that the Fed raises or lowers interest rates to help address increases or decreases in economic activity. Lower rates can help banks to make certain kinds of loans more cheaply, especially for business and certain kinds of consumer lending, and that can help to generate greater economic growth. Higher rates can cool demand, helping to keep inflationary pressures from forming. Expectations of what the Fed may do can be more important than what they actually do, as their actions or inactions can help to confirm or deny what investors believe. This is why the market reacts sometimes strong to the Fed chiefs comments.
You also may have realized that sometimes the Fed cuts interest rates -- and fixed mortgage rates actually rise as a result. Why? If the Fed is taking steps to address economic weakness by lowering rates, that likely means that a return to faster growth and the possibility of higher inflation. Currently we are seeing the weaken dollar and the prices of commodities increasing. What is the Feds next move? I think you may have an idea.
Information Courtesy of Sigma Research