Fed Cuts Rates: Will Mortgage Rates Rise as a Result?

by Alex Stenback on March 18, 2008

Moments ago, The FOMC (Federal Open Market Commitee, or "The Fed") released it’s policy statement accouncing a .75% cut to both the Federal Funds Rate, and The Discount Rate, which now stand at 2.25%, and 2.50%, respectively.  This comes on the heels of a .25% cut to the discount rate on Sunday, and caps off a series of Fed moves that can only be described as extraordinary.

Here is a link to the Full Fed Statement (be patient, the servers are flooded):

Worth noting was this particular passage:

Recent information indicates that the outlook for economic activity has weakened further. Growth in consumer spending has slowed and labor markets have softened.  Financial markets remain under considerable stress, and the tightening of credit conditions and the deepening of the housing contraction are likely to weigh on economic growth over the next few quarters.

Inflation has been elevated, and some indicators of inflation expectations have risen. The Committee expects inflation to moderate in coming quarters, reflecting a projected leveling-out of energy and other commodity prices and an easing of pressures on resource utilization.  Still, uncertainty about the inflation outlook has increased.  It will be necessary to continue to monitor inflation developments carefully.

The bold section (emphasis mine) regarding inflation will be good news for rates if they are correct, but it isn’t time to crack open the champagne and celebrate lower rates just yet.

As we’ve seen with the last five cuts, mortgage rates often worsen within a few days as the markets discount the impact of the cuts.  For instance, the table below shows the activity surrounding the last 5 rate cuts by the Fed:

Date of Cut           Size of Cut     Rate Change
09/18/2007          .50%               +.375% in 2 days.
10/31/2007          .25%               +.25% in 5 days
12/11/2007          .25%               +.25% in 3 days
01/22/2008          .75%               +.375% in 2 days
01/30/2008          .50%               +.625% in 13 days

So far, and it is VERY early, mortgage bonds are selling off a bit (though they have improved markedly over the past several days) but only time will tell how this plays out.

The key to understanding this is inflation – the primary threat to lower rates.  As the Fed drops rates, they risk exacerbating inflation, and surely as rain makes the grass grow, inflation causes interest rates to rise.

And of course, whether rates rise or fall, mortgage credit availability continues to be curtailed, resulting in increased down payment/equity requirements and interest rates for many types of borrowers and mortgage products. 

The good news, as always, is that these Fed cuts do lower the Prime Rate, which will make home equity loans and other types of borrowing cheaper.

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