Dear Kevin, I heard some talking head saying that mortgage rates won’t come down until the Fed lowers their rate. But I’m just over here trying to live my life and keep the HOA off my back, not get a minor in macroeconomics. What even is the “Fed” Kevin, and do they control mortgage rates!? TELL ME LIKE I’M 5 PLEEEEEASE.

Roger that, Johnny, let me lay it out for you. We’ll start by introducing the characters in this story:

The Cast

• First, you’ve got THE PEOPLE. You are THE PEOPLE. I am THE PEOPLE. THE PEOPLE are all the little guys out there just living, eating, working, loving, and generally being good citizens.
• Then we have The Fed, who’s official name is The Federal Reserve. We’ll just call them the Fed, and anyone who works there, a Feddy. The Fed is the U.S. central bank (ooooooo, fancy!). Their entire job is to serve THE PEOPLE by ensuring the economy and financial system are in tip-top shape, which specifically means maximum employment and stable prices. They do this several different ways, but the most relevant one to this story is by “Setting the Nation’s Monetary Policy.” Basically, a dozen Feddy’s are in an exclusive, cool-kid clique called the Federal Open Market Committee, or FOMC, and they use a handful of levers to get the effect they want. The biggest lever and the one we’re going to talk about here is setting the federal funds rate, which normally influences other interest rates in the economy.
• Up next, we have Lenders. These folks are not to be confused with investors. Like investors, they have money, except they’re more serious than investors and don’t gamble as much. Imagine a new AI/laser-based popcorn machine company that plans on upending Big Popcorn with their superior technology. Investors hand this startup money in exchange for a little slice of ownership (including a right to a portion of future profits). Lenders, however, prefer to let other people just borrow their money with a stern promise to pay it back plus a little extra. Even if things go badly and AI-Popcorn-Startup is crushed by Big Popcorn’s massive marketing machine, they can still demand their money back from the beaten-down company. The investors in AI-Popcorn-Startup, on the other hand, are sad and don’t get any money. Because there were no profits.
• Next up is Supply & Demand. These 2 are inseparable. Always holding hands and engaging in an uncomfortable amount of PDA. Always reacting to each other.
  • Supply is nothing but stuff people want. Goods. Services too. Tires, iPhones, your budgeting app, your landscaper’s talented shrubbering—anything you pay money for. Supply is just how much of that stuff is available.
  • Demand is the more dramatic of the 2. It’s how many people want some of supply’s stuff and how badly they want it.
• Finally, we’ve got Inflation. Exactly what it sounds like. The general increase in prices in supply’s basket of stuff over time.

The Story

So we’ve got THE PEOPLE out there being good people and stuff. The Fed, like a kindly grandfather, is watching over them in their little valley with crinkled and watchful eyes. Most of THE PEOPLE have jobs, which is good. And the price of bread has been relatively the same for years. Everybody who wants some bread can buy some, and there is just enough bread for everyone to buy. No more, no less. THE PEOPLE are building good businesses that investors are happy to invest in, and Lenders have just enough money to lend to keep them happy. Everyone is content. The Fed sighs and breathes in the cool mountain air as they quietly watch, occasionally making little adjustments to their big lever: the federal funds rate. In their idyllic little utopia, no big bad things happen, The Fed has a pretty boring job, and no one really notices they’re there.

But what happens when THE PEOPLE exist in the real world? Like we do. Let’s play out a couple of different scenarios.

High Inflation Woes

Inflation often shows up because of dramatic tiffs between the annoying couple, Supply & Demand. Specifically, when they’re having a disagreement or Supply and Demand are not equal. Sometimes Supply has way too much stuff. Maybe he thought he had a great idea and wanted to surprise Demand with a dump truck load of new shoes. But…he didn’t ask her about it first. And she doesn’t want any. Supply is high and demand is low. Or maybe Supply saw that TikTok video about those new massaging eye masks and wants 6 million of them. RIGHT NOW. But Supply only has 100,000 in his bag. Supply is low and Demand is high.

In the first case, prices are likely to fall. Supply has way too many shoes, and he only makes money if he sells them. So he’s gotta sell them, even if he loses money on the deal. So he lowers prices to make them more attractive to Supply in hopes he can find a price point she will at least think “Well, that’s a good deal; why not?” But in the second scenario, prices are likely to rise, and our other friend, Inflation, steps into play. Inflation walks up to the couple in conflict and sleazily says, “Hey what’s the fuss about? Ahh I see. Tsk tsk, no, that is not desirable. Well, since Supply here doesn’t have enough for everyone, why don’t we start taking bids to see who wants it the most?” Prices begin to rise as folks who really want the new massaging eye masks start raising fistfuls of money declaring they’ll outbid anyone who thinks they could possibly need the mask more.

Inflation can also happen when prices for raw materials, labor, or anything else needed to produce a good or service rise. When that happens, businesses raise prices to pass along the costs to consumers.

Grandfather Fed Steps In

The Fed is OK with some inflation and even wants a little bit. Specifically, they want to see it average 2%, but things have gotten out of hand in our little valley. THE PEOPLE are upset, and prices are rising. So The Fed heads over to their lever to get things under control. This fun little lever’s technical name is the federal funds rate. Fun Fact: It’s actually a range (like 4.25% – 4.50%), not a specific number. The federal funds rate is the rate that banks charge when they lend money to each other overnight to meet The Fed’s minimum amount of reserves they’re supposed to have on hand. Might need to read that twice. Or skip it. The bottom line is that a higher federal funds rate costs banks more money to do business.

— PLOT TWIST INCOMING! —

Remember Lenders? Well, banks are actually just lenders wearing a fake mustache and glasses. Surprise! At the end of the day, banks are businesses, and businesses in our quaint little valley like to make money. How do banks make money? With money! NOT by charging you fees to keep your money safe. Sure, they make a bit off of that, but their big business is taking your money and then lending it out to other folks, charging some interest, and sharing a piece of that with you. In reality, as soon as you give your money to the bank <cough> Lender <cough>, they say thank you, make a show of putting it into the vault, and lock the 27 locks on the huge door. Then, after you confidently walk away, another guy opens a little door in the back of the vault, sweeps your money out, and brings it back to the teller in the front, who lends it out to the guy who was in line behind you and wants to buy a new boat. CliffNotes: Banks make money by lending out money. The more money they have to lend, the more money they can make.

— END PLOT TWIST —

So if a bank’s product is essentially money, when The Fed starts making it more expensive to get more money by increasing the federal funds rate, it becomes more expensive for banks to run their business. They then pass these increased costs on to THE PEOPLE in the form of higher interest rates on their products (auto loans, home loans, lines of credit, etc.). And when The Fed wants more people to get out there and spend more money, they decrease the federal funds rate. This makes it cheaper for banks to borrow more money and therefore cheaper for them to lend money to you. And that, my friends, is how Inflation & The Fed affect your mortgage rates.

Mixed Feelings Ever After

Grandfather Fed has a tough job. None of THE PEOPLE think of him when times are stable, but when he has to use his levers to increase or decrease economic activity in response to inflation or employment, THE PEOPLE either attempt to worship him as a god or howl with rage. They praise him as the savior of the economy handing out basically free money, or they raise their fists and curse mortgage rates or how hard it is to find a job. THE PEOPLE’s joy and pain is real, for sure. But now that you know enough to be a bit dangerous in opinionated conversations, just remember that The Fed was ultimately created to make more good times and prevent bad times. So remember to thank them when times feel good, and if you are unhappy with the Feddies during the bad times, then get educated on who might make a good Feddy, and go vote. Feddy members of the Board of Governors (7/12 members of the Federal Open Market Committee) are appointed by the President and confirmed by the Senate.