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November 25, 2009

The Fed Fund Rate: Establish or Influence?

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I am always interested in what drives the economy and you often hear talk about whether or not the Fed fund rate truly drives the economy.

Dan Green wrote a clear concise article on the Fed fund rate vs. the 30-year mortgage rate. There are many misconceptions, media driven I suspect, that the Fed establishes mortgage rates, however, that is not the case. As Dan points out in his article, "The Federal Reserve Does Not Make Make Mortgage Rates (And Here’s Your Proof)", the Fed merely influences rates. defines influence as the capacity or power of persons or things to be a compelling force on or produce effects on the actions, behavior, opinions, etc., of others.

It also defines establish as founding, instituting, building, or bringing into being on a firm or stable basis.

These definitions are important as you review the data.

The chart in the article is supposed to reveal this quickly and easily, but it does not. On a dual axis line chart, it measures the Fed Funds Rate vs. the 30-year fixed mortgage rate. (I'm not allowed to reproduce the image, so here is a link to it.) I cannot make heads or tails of the influence one measure has on the other on Dan's chart because there is only one line.

A dual axis chart is supposed to have two lines. The chart should look like this:

Quickly scanning this chart, there appears to be a pretty strong correlation between the two measures. The 30-year mortgage rate generally follows the same pattern as the Fed Fund Rate. If the Fed established mortgage rates, then the pattern of the 30-year mortgage would follow the pattern of the Fed Funds Rate exactly.

I wanted to verify that the Fed is only an influencer using a scatter plot. If the Fed indeed established rates, you would expect the points to line up nice and neatly.

The scatter plot strengthens the notion that the Fed rate has a significant influence on the 30-year mortgage rate, but does not establish mortgage rates.

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