The
Feds raising rates might be a good thing for all of us!
Today the Fed moved the Fed Funds rate up by 0.50%, which is
the second increase this year. In March
they increased it by 0.25%. The
expectation going into the rest of the year is that the Fed Funds rate will
continue to move up until it has met its goal of containing inflation
pressures.
Whenever the Feds increase or decrease the overnight rate,
we receive an influx of inquiries for mortgage refinances and purchases. Today I wanted to explain the relationship
between the Fed Funds rate and mortgage rates.
One of the biggest misconceptions is that when the Fed Funds
rate goes up, mortgage rates will go up.
And when the Fed Funds rate goes down, mortgage rates will go down. I do admit that sometimes it does happen that
way, but in many cases, it is pure coincidence.
Truth be told that there is no direct correlation between the two.
I think the first thing to understand is what controls
mortgage rates. Mortgage rates are tied
to long-term bonds called mortgage-backed securities (MBS). These MBS are sold to investors and return a fixed
rate of interest. The loans inside of
the MBS average a higher interest rate than what the bond is paying out. This ensures the bond is sustainable and a
safe investment. The bond will pay out a
fixed rate to investors for the life of the bond. So, if the bond contains 30-year mortgage
notes, then it will pay out for 30 years at a fixed rate.
Now let’s talk about inflation. Inflation is the rate of increase in prices
over a given period. Let’s say a Spam
musubi costs $2.00 today. Then let’s say
1-year passes and that same Spam musubi now sells for $2.25. That musubi is now
12.5% more than it was last year. This
is inflation! You need more of yesterday’s
dollars to buy the same product in the present day.
Now let’s talk about the relationship between bonds and
inflation. Bonds return a fixed rate of
return on investment. If the rate of
inflation is greater than the rate of return on the bond, then that investor
will lose money. The only way for a
long-term bond to counteract higher inflation is to increase the fixed rate of
return on said bond. If the bond, in
this case, an MBS, must return a greater yield, then the only way to do that is
to increase the rates on the mortgage loans secured to that bond. This is what makes mortgage rates increase!
Lastly, let’s talk about the Fed Funds rate and
inflation. The Fed Funds rate or
overnight rate is the cost to banks when they borrow money from the Federal
Reserve. The bank borrows from the Federal
Reserve and then lends the consumer the money at a higher rate. If the Fed Funds rate goes up, then the bank’s
loan rate to the consumer will also go up.
These rates are usually tied to shorter-term loans like credit cards and
personal loans. The idea is that if
short-term lending becomes more expensive, then in general consumers will spend
less. If consumers spend less, then
inflation will slow down because the demand for things will slow down.
Bottom line is that the Feds increase Fed Funds rate to slow
down inflation. So as counterintuitive
as it seems, the act of raising the Fed Funds rate could actually bring
mortgage rates down if inflation is tamed.
There are a lot more factors that play into all of this, but I wanted to
clear up the misconception that the Fed Funds rate is directly correlated to
mortgage rates. If there are other
topics that you like me to cover next month, please send questions to admin@smartmoneyhawaii.com and
we’ll try to cover them in the next newsletter.
Mahalo,
Daryn Ogino
Smart Money Hawaii - President
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