Rates are cyclical – they go up, and they go down. When we hear that the Fed has just raised or lowered rates, people think that mortgage rates just went up or down accordingly. But it isn’t quite so simple.
The Federal Reserve conducts monetary policy in order to promote full employment, low inflation (stable prices), and moderate long-term interest rates. The primary tool the Federal Reserve uses to this end is the federal funds rate—the rate that banks pay for overnight borrowing in the federal funds market. When the fed changes the fed funds rate, the discount rate and prime rate change by the same amount. The discount rate is the interest rate charged by the Federal Reserve to member banks when they borrow money from the Fed’s discount window. The prime rate is the interest rate that banks charge their best customers, and is also used as a benchmark for other loans, such as credit card and auto loans.
Changes in the federal funds rate influence other interest rates that in turn influence borrowing costs for households and businesses . When it costs more for banks to borrow, mortgage rates go up. The Fed attempts to be transparent and share information so that their future moves are well anticipated and the markets are not surprised. Markets tend to overreact when they are surprised. Bond traders, economists, bankers, investors, pundits, etc. all parse the Fed’s regular statements to project the likelihood of a future rate change. In most cases, when the Fed moves rates up or down, the change was will have been well anticipated, and so mortgage rates generally do not move at all, since this information was already baked in. However, when the Fed makes a move that is different from what was anticipated, markets can be surprised and mortgage rates can quickly up or down.
In June 2022 the annual inflation rate in the US hit a 40 year high of 9.1%. In July, inflation dropped to 8.5% – still a high number but we are finally going in the right direction. The Federal Reserve target for inflation is 2 percent, – considered to be a healthy rate which can help stave off deflation in the event of an economic downturn. Today’s high inflation was driven by hot economy, supply chain issues, and a very low unemployment rate. The fed is attempting to cool the economy by raising the cost of borrowing – being careful not to overdo it and slow the economy too much.
At the beginning of the Covid-19 Pandemic, when the world was facing a large economic downturn – the Fed lowered rates to near zero in order to make it cheaper to borrow money. When money is cheaper, households are more willing to buy goods and services, and businesses are in a better position to survive, and even to invest in property and equipment and expand their businesses. Businesses can also hire more workers, influencing employment. The stronger demand for goods and services may push wages and other costs higher, influencing inflation. And so the fed must walk a fine line and not overheat the economy – causing inflation and all of its associated perils. The whole process reminds me of what my former boss used to call a soup sandwich. Very hard to get your hands wrapped around.