When the Fed cuts rates

This has to be one of the questions I get asked the most by clients and Realtors alike:

What happens to mortgage rates (and why) when the Fed lowers their rates?

The short answer is mortgage rates tend to go up after the Fed announces a rate cut. "But that doesn't make sense -- shouldn't mortgage rates go down if Fed rates are cut?"

It's widely known when the Fed will meet to discuss rates; analysts across the board give opinions about what the Fed will do -- raise or lower rates and by how much they think they'll move. These opinions are out in the general financial markets weeks before the Fed actually meets. And the analysts are good at what they do -- they may not be spot on, but they're usually pretty close.

Because we "know" a couple weeks ahead of time what we think the Fed is going to do, the market generally prices in that opinion before the actual announcement is made. Once the rates are adjusted by the Fed (or unadjusted, for that matter) the market shifts again.

For example, say the Fed is meeting in two weeks and it's expected they they will lower rates by .5%. In the two weeks leading up to the announcement the financial markets "price in" the coming rate cut. The markets may decline slightly, bring mortgage rates down with them. Then the Fed meets. Say the analysts were right on track and the Fed drops rates by .5%; the markets had already accounted for that cut and so they remain relatively unchanged after the announcement, with potential for a slight increase. The market is happy since they correctly predicted what the Fed was going to do and the market rallies and goes up -- mortgage rates go up too.

Now, say the analysts were a little off the mark. The Fed still reduces rates, but by only .25%; the market has already pre-priced in a .5% decrease in rates -- whoops, too much decline. The economy isn't in a place where it needs a whole .5% cut; the market is happy that the economy's doing better than predicted and it goes up, mortgage rates go up too.

Okay, so what if the market predicted .5% and the Fed lowers rates by .75%? Now the economy needed a bit more of a boost than the .5% would give. The market priced in .5% cut weeks ago, but now things look worse on a macro-economic scale. The market may decline, mortgages rates should drop too.

What happened in January? The Fed was scheduled to meet (and expected to reduced rates) on the 30th. Martin Luther King, Jr.'s birthday (observed) fell on Monday, January 21st. The US markets were closed for the holiday. Before the markets opened on Tuesday, the Fed held an unscheduled meeting and reduced rates by .75%. This unexpected, unscheduled reduction a week before the scheduled meeting was to take place shocked the market to a 300 point decline. Mortgage rates fell. Wednesday morning things looked about the same -- market declines all over the place were holding strong. Then there was a shift; the market turned around. By Wednesday afternoon the market had gained 600 points -- 180 degree turn around! Mortgage rates jumped right back to where they were the previous week. And we still had to hear what the Fed would do in their scheduled meeting the following week (they dropped the Fed rates again, this time by .5% and the mortgage rates rose slightly and then dropped slightly ultimately having no meaningful effect).

The rates that the Fed raises & lowers is not any rate that you or I would see on any of our bank statements. "Fed Funds" is the rate that banks can borrow money from each other to keep their reserve amounts in line. The "Discount Rate" is the interest rate at which an eligible financial institution may borrow funds directly from the Federal Reserve when their reserves dip below the reserve requirement. The Discount Rate is considered the last resort for banks, which usually borrow from each other. The Federal Reserve can change either, but they can't change mortgage rates. The Fed's job is to control inflation while maintaining moderate growth. Their job is not to support the stock or bond market.

That's the long and the short of it. So if you're looking to lock in a rate for your mortgage, you're usually better off getting something in place before the Fed makes any announcements -- I can always renegotiate your rate with a different investor should rates fall later :)