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Economic SYNOPSES
short essays and reports on the economic issues of the day
2004 ■ Number 21

Can a Summer Hike Cause Surprise Fall for
Mortgage Rates?
Kristie M. Engemann and Michael T. Owyang

A

tations. 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 borrowers may have moved
their purchase and refinancing decisions forward. ■

Percent
7.00

Mortgage Composite Index, SA
2000.0

6.00

1800.0

5.00

1600.0

4.00

1400.0
1200.0

3.00
2.00

1000.0
800.0

1.00

600.0

0.00

400.0

01
.N
ov
.0
2
10
.Ja
n.
03
21
.M
ar
.0
3
30
.M
ay
.0
3
08
.A
ug
.0
3
17
.O
ct
.0
3
26
.D
ec
.0
3
05
.M
ar
.0
4
14
.M
ay
.0
4
23
.Ju
l.0
4

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 mortgages
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, borrowers 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; however,
within those two periods, the 30-year fixed rate moved
continually, due partially to fluctuating inflation expec-

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.

Views expressed do not necessarily reflect official positions of the Federal Reserve System.

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