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Despite all the attention the Federal Reserve Board has gotten lately, there seems to be quite a bit of confusion about what its actions mean for mortgage rates. Some borrowers have asked whether they should lock in ahead of Fed meetings because they're afraid any increase will boost mortgage rates immediately thereafter. Others have said they don't understand how lenders set mortgage rates at all.
With that in mind, we've decided to roll out a quick primer on the interaction between mortgage rates and Fed rate hikes. After all, the Fed looks to be an active player in the interest rate game at least into the fall and borrowers who don't know why that matters could easily get burned.
Now that everyone has their No. 2 pencils sharpened, realize that mortgage rates ebb and flow with the bond market. If some event spurs inflation fears in the market, bond yields and mortgage rates will climb even if the Fed hasn't done anything yet. That's because scary inflation data increases the chance the Fed will hike rates later. Almost anything can drive yields and rates higher in this manner, but government and private economic reports, currency and stock market moves, and prognostications from Fed officials and other prominent economists tend to affect them the most.
This mortgage rate-setting process differs from the process by which lenders set rates on auto loans, home equity loans and lines of credit, and credit cards. Lenders typically adjust those rates to changes in The Wall Street Journal prime rate. The prime rate, in turn, changes when the main rate the Fed controls, called the Federal Funds rate, changes -- not when the market's perception of inflation risk does.
Here's an example for the class: In October 1993, the Fed Funds rate had dropped to 3 percent and the prime rate to 6 percent because of several Fed rate decreases. During that time, the 30-year fixed rate mortgage average dropped to a very low 6.64 percent. But in September 1998 -- with the funds rate at 5.25 percent and the prime rate at 8.25 percent -- 30-year rates got almost that low, touching 6.7 percent. Why? Because bond market yields plunged further in 1998 than they did five years earlier. This happened because the bond market was in an uproar and there was rampant concern about deflation, or the opposite of inflation, in the more recent period.
The close interaction between the bond market and lenders means mortgage rates are much more volatile today than in the past. But it also works to a borrower's advantage in some cases.
Think back to 1994 and early 1995, when the Fed rescinded 1993's largesse by jacking the 3 percent funds rate all the way up to 6 percent. Market participants feared the Fed and inflation so much at the time that they drove 30-year mortgage rates up to a monthly average peak of 9.06 percent during that rate-hiking cycle.
This time around, however, they're more confident in Fed Chairman Alan Greenspan's ability to fight inflation successfully with less rate hikes. So even though the funds rate, at 6.5 percent, and the prime rate, at 9.5 percent, are higher now than they were then, the average monthly rate on 30-year mortgages peaked out at 8.57 percent in May. Rates have fallen into the low 8-percent range in the weeks since then.
What lessons should home buyers learn from all this? Remember that the market's perception of inflation and Fed moves -- rather than the moves themselves -- drive mortgage rates. If you think the fact the Fed didn't hike rates this week means mortgage rates won't rise until the Fed's next meeting Aug. 22, you're wrong. Instead of focusing on the meetings, shoppers who want to stay on top of interest rate trends should follow the market and its reaction to economic data.
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