The Federal Reserve closed their September meeting with no change to the federal funds rate, but monetary policy is changing. The central bank announced an October start for trimming its massive holdings of Treasury bonds, agency bonds and mortgage-backed securities (MBS). The process will start slowly and pick up speed over time (the process is detailed below) but the effect on long-term interest rates and mortgage rates should be minimal. With mortgage rates still closer to record lows than not, even as much quarter-point bump in fixed rates from present levels would only bring us closer to 2017 highs, and the gradual process shouldn't bring any direct and measurable immediate impact, anyway.
Despite solid labor markets and an economy that hit a 3 percent growth rate in the second quarter, inflation remains benign, if perhaps slightly less so of late. With this in mind, many Fed watchers and analysts began to believe that the Fed would not make another change to short-term rates this year. However, the Fed's own quarterly Summary of Economic Projections (Fed members assessments of growth, inflation, unemployment and the path for interest rates) suggests otherwise. In the latest update growth for the year was moved higher and inflation lower, but 11 of 16 members still fully expect another 25 basis point lift in the Fed funds rate this year. Most likely, that will come in December. As such, investor positions expecting no change until 2018 are being revised in the aftermath of meeting, and interest rates continue to firm a bit.
The Fed is likely to lift policy at that time as it believes "...that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace, and labor market conditions will strengthen somewhat further. Higher prices for gasoline and some other items in the aftermath of the hurricanes will likely boost inflation temporarily; apart from that effect, inflation on a 12-month basis is expected to remain somewhat below 2 percent in the near term but to stabilize around the Committee's 2 percent objective over the medium term."
On a longer-term basis, it may be that this Fed interest-rate will end with rates well below historic norms. Projections for the federal funds rate over the "longer run" (beyond 2020) envision the key short-term policy rate averaging perhaps 2.8 percent, which would be a percentage point or more lower than history would suggest. It is also the lowest figure since these projections began to become available a few years ago. If the Fed does move the federal funds rate to a range of 1.25 percent to 1.5 percent come December, the cycle of interest rate moves may be more than halfway completed. Such a shallow cycle may leave the Fed with less interest-rate "fire power" to combat the next recession when it ultimately arrives.
What is the federal funds rate?
The federal funds rate is an intrabank, overnight lending rate. The Federal Reserve increases or decreases this so-called "target rate" when it wants to cool or spur economic growth.
The last Fed move, on June 14, 2017 was the fourth increase in the funds rate since 2006, and continues what is expected to be a protracted "tightening cycle" for interest rates, the first that we've seen since 2004. At that time, the Fed embarked on a campaign which featured increases in the overnight rate for 17 consecutive meetings. During that cycle, the federal funds rate rose from 1 percent on June 25, 2003 to 5.25 percent on June 29, 2006.
By the Fed's current thinking, the "neutral" rate for the federal funds may be as low as 3 percent, so even as rates do rise over time, they may not get close to historic "normal" levels.
The Fed can either establish a range for the federal funds rate, or may express a single value.
Related content: Federal Funds Rate - Graph and Table of Values
How does the Federal Reserve affect mortgage rates?
For the most part, the Federal Reserve has only had an indirect impact on most mortgage rates, especially fixed-rate mortgages. That changed back in 2008, when the central bank began directly buying Mortgage-Backed Securities (MBS) and financing bonds offered by Fannie Mae and Freddie Mac. This "liquefied" mortgage markets, giving investors a ready place to sell their holdings as needed, helping to drive down mortgage rates.
Although the program of MBS and debt accumulation by the Fed has ended, they are still "recycling" inbound proceeds from maturing and refinanced mortgages to purchase replacement bonds. This keeps their holdings level and provides a steady presence in the mortgage market, which helps to keep mortgage rates steady, too. It is this process which is beginning to change, and will continue to change as time rolls forward.
Throughout 2017, the Fed has been actively discussing how to best wind down its "balance sheet" (holdings of Treasuries and MBS). The Fed recently announced that the process would start in October 2017, following a plan laid out in June 2017, where the Fed will trim back the amount of reinvestment it is making in steps until it eventually is actively retiring sizable pieces of its holdings.
Initially, and then in three-month intervals, purchases of new Treasury bonds will be pulled back by $6 billion per month and MBS and agency bonds at $4 billion per month. After 3 months, the $6 billion and $4B will be turned into $12 billion and $8B respectively; after three more months, this will rise to $18B and $12B and will ultimately end up as $30B in Treasuries retired each month and $20B of mortgage-related debt.
With a balance sheet comprised of $2.46 Trillion in Treasuries and $1.78 trillion in MBS and agency debt, it will be a long time before these holdings are pared down to what is expected to be a final balance of perhaps around $2 trillion or so, and likely one solely comprised of cash reserves and Treasury bonds.
While the amount or Treasuries the Fed holds and their maturities can be well graphed -- that is, a fairly predictable reduction process can be plotted -- that's not so much the case with mortgages, at least at the moment. Mortgage rates lower than expected and increases in refinancing may increase for a time the amount of mortgages being pulled out of the Fed's holdings, returned the market in new originations and eventually back into new MBS that the Fed will continue to buy (at least when MBS issuance is in excess of $4B (or $8B, $12B, etc.) in a given month.
So far in 2017, the Fed has "recycled" more that $142 billion of MBS; if the plan was already in place, perhaps a third of these would have needed to be absorbed by private investors, which might have lifted mortgage rates a marginal amount. Some analysts reckon that when the program is fully underway it could make fixed-rate mortgages perhaps a quarter percentage point higher than they would otherwise be in "normal" market conditions, so the effect on mortgage rates should be only modest.
Will mortgage rates rise, and why?
For this cycle, and for the moment, more important than any small change in the overnight rate is that the Federal Reserve continues its program of buying Mortgage-Backed Securities (MBS) and Treasuries, even if this reinvestment will start diminishing over time.
The Fed has a massive portfolio of these investments and as they mature or have been paid off (by refinancing) the central bank had been re-investing the inbound funds into more purchases, keeping its portfolio at a constant size. The tapering and eventual termination of the program means that a large regular buyer of these instruments will begin to step out of the market, so at times there may be more supply than demand for MBS. As discussed above, in turn, this will tend to lift mortgage rates to a degree; that said, the prospects for inflation and continued economic expansion will play a greater role in dictating how interest rates will move.
What the Fed has to say about the future – how quickly or slowly it intends to raise rates in 2017, 2018 and beyond – will determine if mortgage rates will rise, and by how much. At the moment, the path for future changes in the federal funds rate is expected to be a gentle upslope, so the upward push for mortgage rates should be gradual, but this may change over time.
Does a change in the federal funds influence other loan rates?
Although it is an important indicator, the federal funds rate is an interest rate for a very short-term (overnight) loan. This rate does have some influence over a bank's so-called cost of funds, and changes in this cost of funds can translate into higher (or lower) interest rates on both deposits and loans. The effect is most clearly seen in the prices of shorter-term loans, including auto, personal loans and even the initial interest rate on some Adjustable Rate Mortgages (ARMs).
However, a change in the overnight rate generally has little to do with long-term mortgage rates (30-year, 15-year, etc.), which are influenced by other factors. These notably include economic growth and inflation, but also include the whims of investors, too. For more on how mortgage rates are set by the market, see "What moves mortgage rates? (The Basics)."
Does the federal funds rate affect mortgage rates?
Whenever the Fed makes a change to policy, we are asked the question "Does the federal funds rate affect mortgage rates?"
Just to be clear, the short answer is "no," as you can see in the linked chart.
That said, the federal funds rate is raised or lowered by the Fed in response to changing economic conditions, and long-term fixed mortgage rates do of course respond to those conditions, and often well in advance of any change in the funds rate. For example, even though the Fed was still holding the funds rate steady in autumn 2016, fixed mortgage rates rose by better than three quarters of a percentage point amid growing economic strength and a change in investor sentiment about future growth and tax policies during the period.
What does the federal funds rate directly affect?
When the funds rate does move, it does directly affect certain other financial products. The prime rate tends to move in lock step with the federal funds rate and so affects the rates on certain products like Home Equity Lines of Credit (HELOCs), residential construction loans, some credit cards and things like business loans. All will generally see fairly immediate changes in their offered interest rates, usually of the same size as the change in the prime rate or pretty close to it. For consumers or businesses with outstanding lines of credit or credit cards, the change generally will occur over one to three billing cycles.
Related content: Fed Funds vs. Prime Rate and Mortgage Rates
After a change to fed funds, how soon will other interest rates rise or fall?
Changes to the fed funds rate can take a long time to work their way fully throughout the economy, with the effects of a change not completely realized for six months or even longer.
Often more important than any single change to the funds rate is how the Federal Reserve characterizes its expectations for the economy and future Fed policy. If the Fed says (or if the market believes) that the Fed will be aggressively lifting rates in the near future, market interest rates will rise more quickly; conversely, if they indicate that a long, flat trajectory for rates is in the offing, mortgage and other loan rates will only rise gradually, if at all. For updates and details about the economy and changes to mortgage rates, read or subscribe to HSH's MarketTrends newsletter.
Can a higher federal funds rate actually cause lower mortgage rates?
Yes. At some point in the cycle, the Federal Reserve will have lifted interest rates to a point where inflation and the economy will be expected to cool. As the market starts to anticipate this economic slowing, long-term interest rates may actually start to fall even though the Fed may still be raising short-term rates. Long-term rates fall in anticipation of the beginnings of a cycle of reductions in the fed funds rate, and the cycle comes full circle. For more information on this, Fed policy and how it affects mortgage rates, see “Federal Reserve Policy and Mortgage Rate Cycles ."
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