3/15/2017 | Casey Fleming
As anticipated, the FOMC – the Federal Open Market Committee of the Federal Reserve (or simply, “The Feds”) – voted to raise interest rates today, raising the discount rate from 0.75% to 1.000%. So, everyone wants to know why mortgage rates dropped this afternoon. Yes, that’s correct – dropped. Shortly after the announcement that they were raising rates, almost all lenders sent over new pricing that was better than this morning.
It’s a good time to revisit the conversation about the difference between the short-term rates that the Federal Reserve controls, and the long-term rates like bonds and mortgages that are set by market forces.
The Feds raised the federal funds rate – the interest rate that banks and credit unions lend money to each other overnight to meet reserve requirements – by 0.250%, from 0.750% to 1.000% today. They raised the rate in order to slow down economic growth and to fight off inflation.
Rising interest rates mean less buying power
When the short-term rates increase, the Prime Rate goes up, and that drives up the interest rate on all short-term borrowing, such as credit cards and home equity lines of credit in particular. Rising interest rates mean higher monthly payments and therefore less buying power for consumers.
Less buying power means that the U.S. economy – which is highly dependent on consumers – will slow down. Decreasing demand for goods and services lessens the pressure of rising prices, because fewer people are competing for those goods and services.
And, voila! Inflationary pressure diminishes.
But we asked why mortgage rates dropped this afternoon
Long-term rates are highly dependent on inflation. If lenders lend out money at an interest rate that is less than inflation, the money they get back in the form of principal and interest is worth less (in terms of buying power) than the money they lent. That makes no sense, so investors worry about inflation and always aim to earn more than that. Remember they are lending money out over 30 years at a fixed interest rate; that’s a long time to have to guess what inflation will be so they can beat it.
So, investors feel comforted if they know that someone has their foot on the brake if the economy heats up too fast and the risk of inflation grows too great. That someone is the Feds.
Let’s go back to the top. The Federal Reserve raised the (short-term) federal funds rate to decrease inflationary pressure.
Long-term investors hate inflation, and need to earn more if it is rising. They will accept a lower rate of return if inflation is under control.
So, when the Feds raise short-term interest rates, investors are willing to invest in long-term investments at lower interest rates, and long-term interest rates fall.
And that is why mortgage rates dropped this afternoon.
This article represents the opinion of Casey Fleming, and not necessarily that of C2 Financial. This analysis was prepared with the best information available at the time it was written. Neither Casey Fleming, nor C2 Financial Corp., have any magical insider information about bond markets, real estate markets or mortgage markets that would make economic projections any more reliable than any other source. No warranty is made that the outcome will reflect the projections in this article, and neither Casey Fleming nor C2 Financial Corp. are responsible for decisions that you make regarding your own choices about your real estate or mortgage or those of your clients.
This article is copyrighted and may not be used or reprinted without permission.