January 7, 2025
A lot of interest rate watchers were very confused late last year. As was expected, in their last meeting of the year, the Federal Reserve Open Market Committee lowered rates for the third time in 2024. But interest rates such as mortgages reacted instantly by increasing. How can that be? Doesn’t the Fed control interest rates? Not as directly as you might think – and here is why. When the Fed lowers or raises interest rates, they are really changing the level of short-term interest rates. How short-term?
The Federal Fund rate is the rate that banks charge each other for overnight loans, hence the term “overnight lending rate.” You see, banks have money going in and out every hour and at the end of the day they must keep up their reserve requirements. Overnight is very short-term. When the Fed raises short-term rates, it costs the banks more to borrow and they must raise their rates such as the prime rate to customers in order to continue to make money. But long-term rates are based upon expectations for inflation.
The higher inflation is—the less today’s money is worth in the future — and anyone who lends money must charge higher interest to make a profit in lending in this scenario. The Fed raised rates because inflation was high, and they wanted to bring down inflation. Mortgage rates went up not because the Fed raised their rates, but because of the same inflation threat. Likewise, though the Fed lowered their Federal Funds rates last year, the strong economy has the markets feeling that the inflation battle is not won and there likely will be fewer rate decreases next year as a result. Are the markets right? We will see.
Source: Origination Pro
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