The Federal Funds Rate and Mortgage Rates

Well, the big news yesterday was the FOMC’s decision to lower the target rate for the Fed funds rate 25 basis points from 4.75% to 4.5%. Many homeowners, or potential homeowners, looking to either refinance or get into a new mortgage might think that this is good news for them as it surely means mortgage rates will also drop. Oddly enough, however, this is not really the case.

The Fed funds rate is the Fed’s tool to try to exert some control on the economy. That is, to either rev it up a bit when things are slowing down or to perhaps reign in inflation when things are getting too hot. Recently, we’ve seen the US economy beginning to slow down, largely due to problems in the housing sector and the credit markets. The Fed fears that if the economy cools off too much we’ll head into a recession. Technically, a recession would be a decline in the Gross Domestic Product (GDP) for two or more consecutive quarters, although that definition is not universally accepted. Regardless, the Fed tries to stimulate things a bit when there is a slowdown by lowering the fund rate to encourage borrowing and get things going.

The Fed fund rate is only indirectly tied to mortgage rates. Speaking broadly and over time, when the fund rate falls 30 year mortgage rates tend to go down as well and vice versa, but not always. The fund rate is more directly tied to adjustable rate mortgages, car loans, credit card interest rates and similar credit areas. Longer term mortgage rates might actually move in the opposite direction than the fund rate, counter intuitive though that be. The reason being that the 30-year fixed mortgage rate is more or less determined by the price of the 10-year Treasury note. That is, the yields on the 10 (and even 30) year Treasury notes are used to set the longer term mortgage rates like the 30-year fixed.