How Fed Funds Rate Cuts Lead to Inflation and Higher Mortgage Rates

The Federal Reserve is expected to lower the Fed Funds Rate Tuesday and that should cause mortgage rates to move higher.

This is a counter-intuitive relationship for most people because when they hear that the Fed is "lowering rates", they instinctively think it means "mortgage rates".

That's not the case at all; the Fed Funds Rate has very little to do with mortgage rates.

If the Fed Funds Rate and mortgage rates were truly related, the chart shown here wouldn't diverge towards the right -- all three lines would move in tandem.

And they don't.

The Fed Funds Rate is an interest rate usually reserved for loans from one bank to another, beginning at the close of the business day and repaid the following morning before the start of the next business day.

This is why the Fed Funds Rate is often called an "overnight rate" -- the money is literally borrowed overnight.

By contrast, mortgage money is typically borrowed over 30 years. This is 10,957 overnight rates strung together and is a completely different risk class altogether.

Fed Funds Rate cuts make mortgage rates go up. The cuts aim to spur economic growth and economic growth can eventually lead to inflation -- the enemy of mortgage rates.

When inflation is present, mortgage rates tend to rise so the more inflation there is, the more mortgage rates will PoP! over time.

Now, for the Fed to simultaneously cut the Fed Funds Rate and guide mortgage rates lower, it would have to gently stimulate the economy and not over-stimulate the economy.

That's a huge challenge because Fed Funds Rate stimulus takes about 9 months to work through the economy and during that year, the Fed would meet six more times.

So, at one meeting, the Fed would cut the Fed Funds Rate and then use the five remaining meetings to see how it all turns out.

The Fed doesn't act like that, however, and explicitly said it doesn't care about long-term inflation risks right now. The major concern is the short-term and to lessen those risks, additional rates cut are in order.

Therefore, markets are now inferring that the Fed will drop the Fed Funds Rate as far as it has to in order to stop a U.S. recession. Markets fear the Fool in the Shower scenario that is now looking inevitable -- economic over-stimulation and long-term, runaway inflation.

It's a terrible outcome for mortgage markets and why cuts to the Fed Funds Rate this week should cause mortgage rates to rise.