Loading ...So hot off the heals of the Fed’s lowering of the Discount Rate by 50 basis points (.5%), there was great optimism that this would give a shot in the arm to the struggling housing market. Much of the population, including many realtors, assume that the Fed has lowered Mortgage Rates, and that it is the Fed that controls the interest rates on mortgage loans. Just to dispel any misconceptions about this, take a look at the graph below. It shows the Federal discount rate, which the Fed just lowered last week, and both conventional (i.e., under $417,000) and jumbo fixed rates. And guess what… after the Fed lowered their rates, the rate on 30 year fixed mortgage loans did change: They went up. (click on graph to enlarge)
So why is this? First the easy part. Long term interest rates are set by the market, not by the Fed. It is the bond market that determines the direction of long term interest rates, and it is subject to our old friends supply and demand. The largest factors for the direction of long term interest rates are the threat of inflation and future strength of the economy, and they are related. So why would the Fed’s lowering of the Discount rate cause long term rates to rise? Because investors view the Fed’s cut of these rates as potentially inflationary, or increasing the risk of future inflation. Further adding to the concern is the government’s moves to add liquidity to the financial markets and banking industry, which while helping the struggling capital markets, also increases the money supply in circulation. Both of these moves can be perceived as adding to the risk of inflation, especially when the cost of energy (oil) is now at an all time high, which is also fuel for inflation. And if the economy heats up on top of these events, we could see more increases in long term interest rates, which is where mortgage rates are tied.
Take a look at this graph. It again shows long term mortgage rates (both conventional and jumbo), and the Purchasing Managers Index, which is an index that predicts the future strength of the economy (there are several). There is a very strong correlation between the direction of the Purchashing Managers Index and long term mortgage rates.(click on the graph to enlarge)
The September jobs numbers are due out in a couple of weeks, and if they show that employment has slowed, and therefore the economy is slowing, then there will generally be downward pressure on long term rates, as there will be less threat from inflation. If, however, the jobs numbers show employment is growing and the economy is heating up, look for increases in long term rates.
This puts us in somewhat of a predicament. On the one hand, the Real Estate Industry wants low, stable long term rates, which means we benefit when the economy slows down (unemployment increases). But of course, if the economy slows down too much, we will be in a recession, and that would be bad for business as well. What we really hope for (and what the Fed is trying to achieve) is slow, steady growth without inflation. The Fed tries to balance this by controlling the Discount rate (the rate banks can borrow money from the Federal Reserve).
I have on occasion heard some people say “Wouldn’t it be great if fixed mortgage rates get below 5%!”. Unfortunately, for that to occur, we would likely have to be in a deep global recession where there is little demand for capital from consumers and businesses, and if that occurs, most people are not going to be comfortable buying anything, let alone a house. Remember, the goal of the Fed is slow, steady, sustainable growth with low inflation. When growth slows too much, or there is risk of recession, the Fed will generally step in and lower the Discount Rate, which in effect lowers short term interest rates. When the economy starts to heat up and inflation becomes a concern, the Fed will generally step in and raise their rates to slow down the economy. Think of this analogy: It is like the Fed is driving a car (the economy), and it alternates between the gas pedal (lowering rates) and the brakes (raising rates). Let’s hope Bernanke is a good driver…
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Let’s Hope Bernanke is a Good Driver