How Market Conditions Affect Interest Rates

Ben Bernanke, Chairman of the Federal Reserve, lowers interest rates, so mortgage interest rates should go lower, too, right? Not necessarily. Here are a few reasons why mortgage rates typically RISE when the Federal Reserve lowers interest rates:

1. When Bernanke lowers “rates,” he lowers the “Federal Funds” rate. It's the interest rate at which large banks lend funds to one another and is a “short-term” rate. Mortgage interest rates are long-term — up to 30 years. Longer-term interest rates are sensitive to expectations about inflation. When short-term rates fall — like the ones the Federal Reserve controls — borrowing and spending usually increase, which can actually cause inflation. Longer-term rates, like mortgage interest rates, can rise when concerns about inflation increase.

2. Markets are often ahead of the Federal Reserve. Mortgage interest rates are determined every day in active public markets. If those markets believe the economy is slowing, interest rates may fall as markets anticipate that the Federal Reserve might lower short-term rates. This happened in the last half of 2000 when mortgage rates began steadily dropping, even though the Federal Reserve left their short-term rates unchanged. The opposite can happen as well. Mortgage rates can rise well ahead of the Federal Reserve increasing short-term interest rates.

It's almost impossible to accurately predict the future of something as complex as the U.S. economy. However, it is important that we, as mortgage consumers, understand some of these market dynamics. Sometimes, a lack of understanding can cost us a lot of money.

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