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Which Leads Which Lower: Mortgage Rates Or The Fed Funds Rate?

2008
01.16

It’s a point that’s always worth repeating:

Ben Bernanke and the Federal Reserve do not control mortgage rates

This is particularly relevant today as newspapers, television programs, and market pundits posit that the U.S. is in the midst of a recession.

The latest evidence supporting that assertion is that Retail Sales grew at its slowest pace since 2002 — the last time the U.S. was in a recession.

Many people fear recessions, but they are natural parts of a business cycle. As the nation’s protector of the economy, though, the Federal Reserve can weaken a recession’s impact on the economy by lowering the Fed Funds Rate.

When the FFR is lower, businesses and consumers pay less interest on business debt and consumer debt, respectively. This leaves more money available to spend on goods and services, thereby providing a subtle boost the economy.

This is why the Fed Funds Rate is integral to financial markets and why it gets so much attention in the press. It’s also why some people are calling for a drastic rate cut at the Fed’s next meeting — many believe that the economy is hurting pretty badly.

It’s not a coincidence that this outlook is causing mortgage rates to fall.

When Corporate America is struggling (or expected to struggle), investors don’t like to be over-exposed to the stock market because of its variable nature. By contrast, the fixed returns of the bond market provides a little bit more safety.

As demand for stocks wanes during a recession, therefore, demand for bonds can pick up.

Ben Bernanke and the Federal Reserve do not control mortgage rates.

Mortgage rates can fall at times like this because rates are “born” from the price of mortgage bonds. The higher the price, the lower the corresponding rate.

So, as investors leave the stock market and buy bonds — including mortgage bonds — the increased demand raises prices and pushes mortgage rates lower.

All of this happens independent of the Federal Reserve — it’s a natural function of the stock and bond markets.

The Federal Reserve does not control mortgage rates but it does control the Fed Funds Rate. And both tend to respond to economic weakness.

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