Why do mortgage rates increase when the Fed reduces rates?

Followers of financial news may have observed something peculiar: when the Federal Reserve announces a rate reduction, mortgage rates actually go up! We'll try to understand why.

The Federal Funds Rate and Mortgage Rates: Two Differing Worlds

To be clear, when cutting the federal funds rate, the Fed can only have an effect on short-term loans such as personal or business loans and credit cards - not longer term mortgage loans. Federal funds rate refers to what banks charge each other for overnight loans - personal, business or credit card. Investor expectations regarding inflation and economic growth also affect mortgage rates in turn affecting short-term loan interest rates.

Why do mortgage rates rise after a Federal Reserve interest rate cut?

Here's one way of looking at it:

1. The Federal Reserve lowers rates to promote economic expansion. The lower federal funds rate provides businesses and consumers with an incentive to borrow less, thus lowering borrowing costs.
2. Investors are concerned about inflation. Inflation can worsen as an economy expands rapidly, diminishing loan values over time and making lenders uncomfortable.
3. Mortgage interest rates increase in order to protect lenders. Lenders raise mortgage rates to offset inflation risk and ensure long-term profitability.

The Short-Term vs. Long-Term Borrowing Divide

Mortgage rates are long-term loans that respond to inflation rather than immediate changes in federal funds rate. Therefore, when borrowing costs decrease due to Fed rate cuts for short terms loans, mortgage rates become an important indicator. They're determined by bond markets and investors' trust; instead of responding immediately to changes in federal funds rate.

The Federal Reserve's rate cut has had multiple effects on short-term borrowing.

Short-term loans generally see reduced interest rates when the Federal Reserve reduces rates.

1. Credit Cards - Interest rates could decrease, making carrying a credit card balance more manageable and affordable.
2. Personal Loans with Short Repayment Terms: Inexpensive and flexible personal loans may offer better value for you.
3. Payday Loans: Although payday loans may see reduced rates, they will remain expensive options.
4. Lines of Credit - Both businesses and individuals can obtain lower interest rates from credit lines.
5. Business Loans: Companies borrowing short-term may find more favorable loan terms.
6. Overnight Lending: Banks lend to each other overnight to reduce rates and keep the financial markets stable.
7. Treasury Bills - Short-term government bonds may offer lower yields.

What this Means to Homebuyers and Owners

Do not assume a Federal rate reduction will automatically mean lower mortgage rates if you are buying or refinancing. Keep an eye on inflation and economic data; short term moves by the Fed tend to have less of an effect than longer-term forecasts on mortgage rates.

Mortgage rates can be complex. While a recent Fed rate cut has made short-term borrowing more affordable, investor expectations of inflation and economic growth play a greater role in determining whether rates increase or decrease. So the next time you hear that the Fed has cut rates, know why your mortgage rate may not follow suit immediately.