Reader Stephan sent an email asking, “The fed dropped rates, so why aren’t mortgage rates dropping?”
Great question! I know a lot of people hear the news ”” Fed Lowers Rates 0.75%! ”” and they expect that mortgage rates do the same.
Not so much.
The “emergency rate cut” the Fed took on Tuesday dropped the “Fed Funds” or overnight bank to bank lending rate 75 basis points (0.75%). So why didn’t mortgage rates also fall 0.75%?
Because the fed funds rate and mortgage rates aren’t “correlated”. They aren’t tied together so that when one falls the other falls (or when one rises, so does the other). Sometimes they do, sometimes not.
Let’s look at a graphical representation of the correlation between the Fed Funds rate and mortgage rates.
This chart is a “scatter plot”. Each point represents a fed funds rate and the corresponding mortgage rate. The data is from 1971 through this week. The fed fund rate is on the X (horizontal) axis, and the 30 year fixed mortgage rate is on the Y (vertical) axis:
So how do you interpret this thing?
Notice the red box. All those data points jammed in there are telling you that when the fed funds rate was between 1% and 4%, the 30 year mortgage rate was between 5.6% and 6.1%. So a 3% spread in fed rate resulted in a spread in mortgage rates of only 0.5%.
Notice the green box. All those data points are saying, “Look! When the fed funds rate is 6.3 to 6.8%, the mortgage rate can be anywhere between 7% and 11%.” A 0.5% spread in fed rate can corresponds to a 4% spread in mortgage rates.
In other words, the correlation between fed funds rate and mortgage rate is not good. Just because one rate rises or falls it doesn’t really mean the other will.
(Before some statistics wizard jumps all over me, yes the chart indicates some positive correlation. In fact, the correlation coefficient is 0.79. But as a good stats wiz knows, correlation coefficient as a summary statistic shouldn’t replace examination of the data. Just look at Anscombe’s Quartet.)
How the fed funds rate, mortgage rate and every other interest rate out there are manipulated, and the factors that cause them to change is very complex. I am not an economist (nor a lender), just an interested bystander.
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.
Want to learn more?
Texas A&M Real Estate Center: The Fed Rate vs. Mortgage Rates
Here is a nice summary article on interest rates: Interest Rates 101.
And from one of my favorite web sites, How Stuff Works, come these series of articles that may be of interest: How the Fed Works, and How Interest Rates Work.
The Federal Reserve itself chimes in with, “In Plain English: Making Sense of the Federal Reserve”. (PDF)
[tags]Fed Funds Rate, mortgage rates, financial policy[/tags]
The Phoenix Real Estate Guy was started by Jay Thompson, and I have a little blogging problem... he liked to say...
Jay,
Brilliant analysis. It's amazing how mortgage rates rose "astronomically" on Wednesday (the day after the 0.75% Fed cut). Mortgage rates rose further on Thursday. Today (Friday) its been stablizing and tending downwards.
So, the past week has provided a very good example of the point you're making.
Jay,
Thanks for the posts and the links. I was about to write a similar post and really did not know where to go. I just spent a few hours talking with some lenders about the rates, the fed cut and what this means.
Basically clearer answers could of been given 2 years ago. Now even the lenders are uncertain…rules are changing daily on what they can and can't do as far as rates. One thing that was expressed is that this does bode well for clients in good financial standing, good credit scores etc. They can take advantage of this. For first time home buyers, lower credit scores and/or people with little to no down, this fed cut means nothing apparently.
Take care
Jay,
Great explanation and analysis. The great thing about blogging is that it exposes you to so many different topics and opens new areas of learning. Should be required reading in RE 101.
The Mortgage rates are NOT created from MBS yield … Follow the bond market and you'll find your Mortgage rates.
You need to read more about the money/credit/debt cycle. You'll find the reason why so many people are calling for more pain.
Bobby Joe – isn't a MBS a bond? Maybe not, like I said, I'm not a lender or economist. Perhaps I chose the wrong word. Regardless, the main point of the article was that the Fed Funds rate and Mortgage rates are not well correlated. Do you agree (or not) with that?
And whether mortgage rates are influenced by MBS's or the bond market, the fact is they are not controlled by the Fed.
Looking at the chart it looks like regardless of the fed rate, interest rates dont fall much below 5%. Is this generally true? Is their pretty much no chance of ever having a 4% interest rate on a 30 year loan.
We need the FED to just keep on dropping our AZ market is in the toilet at least now with one of the fastest growing populations in America we will tun much soner than later and then back to nice growth rates.
Jay,
Interesting article. I'm a bit surprised though by your comment, "the fed funds rate and mortgage rates aren’t “correlated”. Doesn't the fact that the coefficient of correlation is relativley very high – 0.79 – indicate that in fact there is a correlation? I would agree with you that mortgage rates are not tied to the Fed Funds or Discount Rates, but to say that they're not correlated seems to be missing the point. That's because if you told me the Fed dropped rates, wouldn't I be right about 4 out of 5 times to say that mortgage rates would also drop (vs. go up)?
Keep blogging!
Steven
It is amazing that people still believe this mortgage myth. I have written about this misconception as well.
Overall market conditions affect all rates.