Monday, February 4, 2008

Economist's Notebook: Why Do Mortgage Rates Rise When the Fed Cuts Rates?

This is a question that often perplexes people and it was asked again this week in the Sunday Oregonian to a mortgage broker who basically punted on the answer. She said: "The drops by the Fed do not directly affect long-term, 30-year rates. They do directly affect short-term rates, consumer and auto loans, that sort of thing." Um, OK, but back to the question, why did mortgage rates go up when the federal funds rate target dropped? The answer is complicated. Into the pricing of mortgages go things like risk, expectations of the performance of the economy, etc., but the one of the big ones is expected inflation. It is easy to see why - inflation quickly erodes the return on long-term loans. So what are inflation expectations doing? Let's ask the Cleveland Fed who tracks it. Here is a graph of adjusted 10-year Treasury Inflation-Protected Securities (TIPS):

From the Cleveland Fed: "Because the market's expectations for inflation are priced into one of these securities, the measure that is derived from the yields is a good estimate of the market's estimate of future inflation."

We see that since the late fall inflation expectations have risen steadily. In December and January mortgage rates fell steadily, perhaps thinking that the Fed was on top of this trend, but then mortgage rates jumped back up - right around the last two rate cuts, on Jan 22 and Jan 30. I think it is pretty clear that the mortgage market suddenly started to worry quite a bit about the Fed loosing control of inflation (below is a graph of 30 year fixed interest mortgage rates).

1 comment:

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