The Federal Reserve will be meeting on Jan. 29th & 30th to discuss the state of our economy. Will they cut rates and if yes by how much? Will the rate cuts lead to decreasing or increasing mortgage rates?
There's a lot of confusion about the Fed Funds Rate (FFR) and the typical 30 yr. fixed rate. Do these rates move in the same direction or are they inversely related?
First, let me provide a simplistic definition. The Fed Funds Rate is the rate the Federal Reserve charges other banks for overnight deposits. It is also the rate the Fed uses to control inflation. If inflation starts to rise above the 1% - 2% "neutral" zone, the Fed will usually increase the Fed Funds rate to slow down the economy. If inflation starts to decrease below the 2% level then the Fed will usually start to cut the FFR stimulate the economy.
A Fannie Mae 30 year fixed rate mortgage is actually a bond, also known as a Mortgage Backed Security (MBS). If you are a bond holder (investor), the worst thing for your bond investment is inflation. If inflation is rising, then the value of your bond (30 yr. Fixed rate) is declining, so as an investor you would require a higher rate of return to compensate for the inflation. Here's an example to help you understand.
Bond Holder/Investor: willing to lend $100,000 to a home owner for 30 yrs. expecting a rate of return (interest) of 6% because inflation today is only 3%.
Borrower/homeowner A: willing to finance the home purchase with a loan of $100,000 for 30 yrs. at 6% interest rate.
Let's say a month from now, inflation jumps to 5% from 3%.
The Bond Holder/Investor is still willing to lend $100,000 for 30 yrs. to borrower/homeowner B but because inflation is 2% higher, the investor will charge 7.5% or 8% to compensate for the loss of value of what that note will be worth in 30 yrs.
This is a simplified example, but the point is that normally when the Federal Reserve decreases the FFR, they are trying to stimulate economic growth which means that inflation will eventually start to rise. The 30 yr. fixed rates will start to rise as inflation starts to rise with the economy.
This is not always the case and we are seeing the exception in today's interest rates. The last few FFR cuts led to declining 30yr. rates and part of the reason is that we may be heading into a mild recession. There's an interesting article from Goldman Sachs anticipating that we will have a recession in 2008 and that the Fed Funds Rate will be cut to 2.5% by the third quarter from 4.25% that we are at today.
If this comes to pass and the FFR rate is reduced to 2.5%, we will most likely see 30 yr. fixed rates in the 5% range.
A number of analysts are expecting a .50% rate cut at the Jan. 30th meeting. This will reduce your Prime based interest rates like your home equity line and some credit cards. The Prime rate is just the FFR plus 3%.
Stay posted, because I believe that 30 yr. rates will continue it's trend down and should help homeowners qualify for an inexpensive mortgage to take advantage of the tremendous real estate bargains. Let's help move inventory off the market and get our home values back on the rise.
But Wait There's More:
Jim McMahan, a Mortgage Broker in Texas taught me some guidelines that the FED tends to follow:
1. The FED's goal is to keep Core Inflation (C.I.) at 3% or less. (the PCE is currently at 2.16%)
2. Everytime we've had a recession, the FED has taken the Real Interest rate to a negative number in order to stimulate growth:
Real Interest (R.I.) rate = Federal Funds Rate (F.F.R.) - Core Inflation (C.I.)
(2.09% = 4.25% - 2.16%)
3. Real Interest rates have never increased 8 quarters in a row unless inflation (C.I.) was present at 4.5% or greater.
4. Mortgage Rates in the U.S. have been at or below 7.5%, 85% of the time in the last 80 years.
5. Mortgage rates tend to gravitate towards Core Inflation (C.I.) + 3.5% (2.16% + 3.5% = 5.66%)
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