Why the Fed has little control over mortgage rates
The Federal Open Market Committee (FOMC) adjourned from its second meeting of the year Tuesday and, for the second straight time, the group voted 10-0 to leave the federal funds rate unchanged.
The fact that the fed funds rate is unchanged, however, doesn't mean that mortgage rates are unchanged, too. Mortgage rates and the fed funds rate move independently from one another and recent mortgage market action proved it.
Tuesday, Wall Street rejected the FOMC, deeming the group's statement too soft on inflation. Mortgage rates spiked on the news, adding 0.125% within minutes of its release.
Then, as quickly as rates rose Tuesday, rates plunged Wednesday. Ongoing concerns in Japan caused mortgage rates to reverse course, and by the end of the day, conforming mortgages had dropped to a six-week low.
What are the FOMC and the fed funds rate?
The FOMC is a special group within the Federal Reserve, the government's monetary policy-making arm. Eight times annually, the FOMC meets to discuss economic and financial issues facing the nation, and upon adjournment, the group typically votes to raise, lower or leave unchanged an intra-bank interest rate called the fed funds rate. The fed funds rate is just one of six ways by which the Federal Reserve currently puts monetary policy into action.
In general, when the Fed lowers the fed funds rate, it aims to stimulate the economy into expansion. When it raises the fed funds rate, the Fed aims to slow the economy from overheating. A vote of "unchanged" implies the Fed sees no need for immediate action either way.
Since December 16, 2008, the Federal Reserve has held the fed funds rate near 0.000 percent. As far as Fed tools go, the fed funds rate is maxed out.
The fed funds rate is harming mortgage rates
With each subsequent vote to keep the fed funds rate near zero, the Fed is implicitly telling Wall Street "we don't think the economy can stand on its own, in the near-term." In some economic environments, that message plays well because Fed-led stimulus loosens credit and reverses the inertia of a recession.
In the current climate, however, the message plays poorly. Wall Street doesn't think the economy needs as much help as the Federal Reserve is giving it.
Over the past six months, job growth has returned, manufacturing sectors are strong, and consumer spending is high. These three separate signs of stability suggest that the economy is recovering nicely, and now Wall Street is nervous that the Fed's policies will stimulate the economy straight into inflation. That would be awful for mortgage rates.
Why? It's because of how mortgage rates are "made".
Why mortgage rates are rising
Mortgage rates don't come from thin air; they're made from a math formula, based on mortgage-backed bond markets.
-Be sure to read: "What moves mortgage rates"-
When the demand for mortgage bonds rise, mortgage bond prices rise, too. This leads mortgage rates lower. Conversely, when the demand for mortgage bonds fall, mortgage bond prices fall, as well, and that causes mortgage rates to rise.
It's a simple relationship of supply and demand.
High demand for mortgage bonds was the keystone of last year's refi boom and low rates. This year, demand has been weak. A major reason why is because Wall Street thinks inflation is coming, and inflation devalues the U.S. dollar and everything denominated in it, including mortgage-backed bonds.
So, because Wall Street thinks the Fed's policies invite inflation to the economy, it has started a chain reaction by which demand for mortgage bonds is falling, and mortgage rates are rising.
Lock a low mortgage rate while you still can
Despite the FOMC's inflationary message to the markets Tuesday, conforming mortgage rates are falling. This is because there are counter-forces at play including ongoing turmoil in the Middle East and concerns for Japan's economy post-earthquake.
As some investors flee bonds because of inflation, many more are flocking to bonds because they offer safety of principal. This is keeping rates from rising as they otherwise should.
On Wall Street, fear is trumping optimism.
If you're a rate shopper or a homebuyer, consider locking a mortgage rate with your lender today. Eventually, the Middle East will settle and Japan will recover, but inflation in the U.S. will last.
When that happens, look for mortgage rates to skyrocket.
Dan Green is a loan officer with Waterstone Mortgage in Cincinnati, and the author of the nationally-recognized mortgage blog, TheMortgageReports.com. As well as serving the purchase and refinance needs of his clients, Dan speaks to national audiences about mortgage rates and the mortgage market. Follow him on Twitter at