Federal funds rate ; Mortgages ; Interest rates

Kristie M. Engemann

Michael T. Owyang

English

Research Papers in Economics

September 2004 MonetaryTrends
Views expressed do not necessarily reflect official positions of the Federal Reserve System.
Can a Summer Hike
Cause a Surprise Fall
for Mortgage Rates?
A
fter persistent decreases in the federal funds rate
target for the past four years, the Federal Open
Market Committee (FOMC) increased the target
by 25 basis points at their June meeting. One might assume
that raising rates dampens demand in interest-sensitive
markets, such as housing, but data from the Mortgage
Bankers Association show the opposite can occur. In the
week following the FOMC’s decision, the total number
of mortgage applications (the Mortgage Composite Index)
increased by nearly 20 percent on a seasonally adjusted
basis as the long-term (15-year and 30-year) fixed rates
fell by over 20 basis points. At the time this cover page
was written, mortgage rates continue to be lower and
mortgage demand higher than before the decision to raise
the federal funds rate. 
A funds rate increase can affect the market for mort-
gages in a number of ways, and some examples follow.
Mortgages are long-term loans, meaning that the mortgage
rate depends on both current short-term interest rates, e.g.,
the federal funds rate, and expected future short rates,
which partly depend on inflation expectations. Therefore,
one effect is that, other things equal, an increase in
the funds rate causes long rates to rise. Another
effect is that markets might expect future inflation
to fall when the funds rate increases because this
eases upward pressure on inflation. Thus, when
the funds rate rises, long-term mortgage rates might
remain unchanged or even fall. Additionally, raising
the funds rate has an intertemporal substitution
effect, whereby an increase now might signal that
further increases are impending. As a result, bor-
rowers may decide to apply for mortgages now
before rates become higher. This, in turn, raises
short-run mortgage demand. Assuming expected
inflation does in fact fall, the latter two effects on
mortgage demand counterbalance the first. 
As the chart shows, the funds rate has remained
between 1.00 and 1.75 percent since November
2002, with two long periods of almost no change; how-
ever, within those two periods, the 30-year fixed rate
moved continually, due partially to fluctuating inflation
expectations. Mortgage demand also fluctuated greatly
during this time. For the two funds rate decreases that
are shown, the long rate increased, suggesting that the
increase in expected inflation swamped the effect of the
decline in current short rates. Concurrently, mortgage
demand fell in these episodes, perhaps because of the
combination of the indirect effect of higher inflation
expectations and the lack of a sense of urgency to apply
for mortgages. Since June of this year, when the funds
rate increased, the 30-year mortgage rate has fallen, and
mortgage demand has risen slightly, possibly reflecting
both lower rates and homeowners’ urgency to secure
loans before an anticipated series of funds rate target
increases by the FOMC.
Despite the recent increase in the federal funds rate
target, there was not an immediate increase in long-term
rates and lower mortgage demand. Thus, it is incorrect to
assume that monetary policy tightenings will always curtail
housing in the short run. Nevertheless, coming weeks may
yet see a decline in mortgage applications, as many bor-
rowers may have moved their purchase and refinancing
decisions forward.
—Kristie M. Engemann and Michael T. Owyang
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0.00
1.00
2.00
3.00
4.00
5.00
6.00
7.00
01.Nov.02
10.Jan.03
21.Mar.03
30.May.03
08.Aug.03
17.Oct.03
26.Dec.03
05.Mar.04
14.May.04
23.Jul.04
Percent
400.0
600.0
800.0
1000.0
1200.0
1400.0
1600.0
1800.0
2000.0
Mortgage Composite Index, SA
Federal Funds Rate 30-Year Fixed Rate
Mortgage Composite Index, seasonally adjusted
NOTE: For the mortgage index, the week ending March 16, 1990 = 100.
SOURCE: Mortgage Bankers Association and the Federal Reserve Board.

Can a summer hike cause a surprise fall for mortgage rates?

http://research.stlouisfed.org/publications/mt/20040901/cover.pdf

Can a summer hike cause a surprise fall for mortgage rates?

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