The Federal Reserve cut the key federal funds rate today by 0.50%. It is now 3.00% (which makes prime = 6.00%). Here is a brief snippet of what the Fed said today:
Financial markets remain under considerable stress, and credit has tightened further for some businesses and households. Moreover, recent information indicates a deepening of the housing contraction as well as some softening in labor markets.
The committee expects inflation to moderate in coming quarters, but it will be necessary to continue to monitor inflation developments carefully.
This cut in rates doesn’t mean mortgage interest rates are coming down. Quite to the contrary this move will inevitably move mortgage rates up. This is becuase the Fed move boosts stocks, taking money away from bonds. More importantly this move is inflationary. Inflation is the worst enemy for a long term paper like mortgages. Hence investors (people who buy) mortgage bonds will demand a higher return (hence increased interest rate).
Don’t believe me? Well, last week when the Fed lowered rates by 0.750%, I documented (on this blog) the rise in mortgage rates the following Thursday. Also, Jay Thompson, at Phoenix Real Estate Guy has stasitical evidence which shows that changes to the federal funds rate by the Federal Reserve does not result in a coresponding change in mortgage interest rates:
In a nutshell, the Federal Reserve controls short term rates (such as the rate that was cut on Tuesday). Mortgage interest rates are not controlled by the Fed, they move up and down based on the trade in mortgage backed securities / the mortgage bond market.
I vaguely remember Dr. Duck (his real name), my undergraduate economics professor, saying something along the lines of the Fed primarily manipulates the Fed Funds rate to control inflationary pressure, provide liquidity to the financial markets and to try to balance employment rates, prices and economic growth.
Care to comment? I’d be happy to hear your thoughts.
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on Jan 30th, 2008 at 3:09 pm
It’s really interesting to see this analysis.
In the UK, consumer mortgage rates have historically been MUCH more closely tied to Bank of England MPC rates (our equivalent of the FOMC), because we have two systemic differences:
1: The vast majority of UK home-owners and property investors have short-term mortgage deals (either fixed for 2-3 years or discounted relative to the UK normal rates for 2-3 years, reverting to “normal rates” at the end of the fixed period.)
2: “Normal rates” in the UK are NOT based around selling mortgage backed paper. The securitisation industry in the UK is a tiny fraction of the mortgage industry - the majority of mortgage lenders are putting up their own capital rather than securitising.
However, despite this, UK mortgage rates haven’t gone down since the last MPC cut… the UK analysis is a bit different.
The UK finance industry is interpreting things like last week’s FOMC cut (let alone today’s) NOT as the Fed acting decisively… but as the Fed panicking! That’s meant that lenders are being EVEN MORE cautious about who they lend to, and withdrawing mortgage products left right and centre. With fewer players able to provide a mortgage to any given customer, the customers are, obviously going to pay more since less competition -> worse pricing.
I wonder whether you’re seeing similar effects on your side of the Atlantic?
on Jan 30th, 2008 at 3:42 pm
I think the relationship between the Fed’s rate and Consumer Mortgage interest rates is murky at best. Yes there’s an inverse relationship between stock prices and bond prices, but only to a certain extent. If the Fed keeps lowering rates to 3%, 2%, 1%… we’re not going to see mortgage rates rise to 7%, 8%, 9%…
Rates are tied to mid-long term bonds, since most lenders sell to the secondary market. But if that market is pricing at 8%, some bank is going to say “I can borrow at 2% & lend as much as I want at 7.5% - that’s a heck of a margin.” And they’ll steal as much market share as they want. Simple supply & demand plays a pretty big factor, too.
PS - I posted a couple of days ago about economist John Mauldin’s opinion; today’s rate cut might indicate a bumpy ride ahead for banks and mortgage companies..
on Jan 30th, 2008 at 3:46 pm
Mark,
Thanks for pointing out the differences. Actually, adjustable rate mortgages are affected by the interest rate cut in the same way they are in the UK. However, it’s the fixed 30 year, which is the bread and butter that is not affected. Some ARM’s are tied to the prime rate and hence these would be affected.
I don’t know that too many people in the US are interpreting the FOMC cuts in a positive light. I know Wall Street is loving it, however, its like too much candy after a while. You’ve got to eat something substantial otherwise you’ll only get a stomach ache. I think most analysts understand this and are not liking it too much. I’ve read a few market analysis bloggers complain that something is fishy and they don’t like the smell of it.