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Thinking about buying a home this spring? Check out the latest update to the income needed to buy a median-priced home in the top 50 metro areas.

Thinking about buying a home this spring? Check out the latest update to the income needed to buy a median-priced home in the top 50 metro areas.

HSH.com on the latest move by the Federal Reserve

Keith Gumbinger

There was again no change in the federal funds rate for a fourth consecutive meeting, which is still holding steady at a range of 5.25% to 5.5%. While the key policy rate remains at its highest level since late January 2001, the Fed provided a new signal that the next change in rates -- whenever it may come -- will be a downward one.

It now appears quite clear that July 2023's increase was the last for this cycle. Fed Chair Powell's prepared remarks indicated that the Fed "believe[s] that our policy rate is likely at its peak for this tightening cycle."

As recently as December, the official Fed outlook is that there was a chance of three cute in interest rates this year, but the first trim now isn't likely to come in March or perhaps even May at this point.

To be fair, the economy at the moment doesn't seem to need the additional support that a rate cut will provide. Recent indicators suggest that economic activity has been expanding at a solid pace," noted the statement that closed the latest meeting. At least by the first estimate, GDP growth ran at a pretty warm 3.28% annual pace in the fourth quarter, a second consecutive period of above-potential growth. Continued strong growth may make a sustained return to 2% core inflation more difficult, and might keep the Fed from cutting rates for a while longer yet.

It's also true that inflation continues to run at a level pretty well above the Fed's target. However, the Fed continues to point to progress being made on inflation: "Inflation has eased over the past year but remains elevated," said the meeting-closing statement for a second consecutive time. The Fed's preferred gauge -- core Personal Consumption Expenditure prices -- has come down measurably from peak levels, and on an annualized basis has decelerated to a 2.9% rate through the end of December. Importantly, core PCE has run at or below the Fed's 2% target for about the last six months, but even so, the central bank wants more evidence that the settling of prices will continue sustainably, not just reaching the desired level but remaining there going forward even as policy rates decline. Since in the Fed's view there's not yet sufficient evidence that the inflation goal is in sight, let alone remaining there, it may be another meeting or two before any change in short-term interest rates occurs.

Tight labor markets remain are also on the Fed's mind, of course. The statement noted for a third straight meeting that "Job gains have moderated since early last year but remain strong, and the unemployment rate has remained low." Mr. Powell's prepared remarks for his press conference noted that "The labor market remains tight, but supply and demand conditions continue to come into better balance." The December employment report saw a higher-than-expected 216,000 new hires take place, but 71,000 jobs were subtracted from the November and October reports, tempering the strength of the recent trend for job growth. However, wage growth did pick up a little bit in the latest report and was reckoned at a 4.1% rate over the past year, a level that the Fed feels is still inconsistent with core inflation retreating to target very quickly.

At the December post-meeting press conference, Chair Powell noted that labor conditions are "coming into better balance," pointing to job openings that have continued to move down from record-high levels, more muted hiring and low and steady claims for unemployment benefits. The most recent look at job openings for December found more of them than was expected and there was also an upward revision for November, so employers are still competing for a limited pool of workers. This can pressure wages higher, and the Employment Cost Index -- a measure of the total compensation of keeping a worker on the books pegged wage growth at a 4.3% rate over the last year, a figure stronger than the Fed wants to see.

While there was no decrease in short-term rates today, that doesn't mean one won't be appropriate or necessary in the future. In his prepared remarks, Mr. Powell said that "if the economy evolves broadly as expected, it will likely be appropriate to begin dialing back policy restraint at some point this year. But the economy has surprised forecasters in many ways since the pandemic,.." and the meeting-closing statement said "The Committee does not expect it will be appropriate to reduce the target range until it has gained greater confidence that inflation is moving sustainably toward 2 percent."

None of the information released in either the statement or in Mr. Powell's press conference provided any clues as to the timing of any coming cut in short-term rates. In answering a journalist's question, Chair Powell offered that he didn't think a cut as soon as March was "likely", or at least that wasn't his "base case" for the timing of any coming change to rates.

Odds of Fed rate decreases

Per Fed Chair Powell, the Fed now sees policy as "restrictive", that the key policy rate is "likely at its peak for this tightening cycle. and that, if the economy evolves broadly as expected, it will likely be appropriate to begin dialing back policy restraint at some point this year."

With this in mind, the July 2023 increase in the federal funds rate seems to be the last hike for this cycle. Although it may be restrictive, the current level for the federal funds rate may or may not be sufficient to drive inflation back down to the 2% "core PCE goal the central bank has set, or at least do so very quickly. Even absent any additional hikes, this key rate has already remained elevated for a fair period of time but may remain there for perhaps up to a year. This might put the first decrease in rates in the beginning of May or perhaps even June.

The December 2023 update of the Summary of Economic Projections (SEP) revealed that Fed members expect perhaps three quarter-point decreases in the federal funds rate by year end, up from an expectation of two cuts just three months prior. The median expectation for the level of the federal funds at the end of 2024 is currently 4.6%, down from 5.1% back in September.

It's interesting to consider that in June 2023, the SEP foresaw a full-point cut in rates by the end of 2024; then with a "higher rates for longer" stance forming through September of last year, this rate-cut outlook then suggested only a half-point drop. By December's update, this moved back up to a 0.75% trim over that same time horizon. The longer-range outlook now sees a one-point cut for rates in 2025, a smaller decline for 2026, and the federal funds not approaching its long-run level of 2.5% until 2027 or beyond.

While its both hopeful and encouraging for potential borrowers that rates will likely be lower this year, it's also important to temper that enthusiasm. The reality is that a 4.6% median federal funds rate would return it only to about where it ended 2022 and began 2023... and this would still be as high as this rate was back in 2007 -- so moving only from about 22-year highs back down to 16 year highs. The cost of money will be cheaper, but still by no means cheap.

The December SEP also reflected views that core PCE inflation will be a little lower at the end of the next year than was than expected in September, falling to 2.4% by years' end. Economic growth is expected to generally be a little weaker over the next year than was forecast three months ago, while the unemployment rate forecast was unchanged 4.1% over the next few years. Unemployment is currently a pretty tight 3.7%, and compared to other rate-hike cycles, an upward trend for joblessness to only 4.1% would be quite mild, and anything around 4% might be reasonably considered "full employment", which is the Fed's mandate.

The next Fed meeting comes at in mid-March. Prior to this meeting, futures markets placed only about a 43% chance that the first cut in rates will come; post meeting, this has decreased to only about 36%. After the close of the December 2023 meeting, the probability of a March cut was greater than 78%, so investors have begun to temper their expectations about how soon and how quickly the Fed will be cutting rates. Of course, the incoming data between now and March will have much to say about how much longer the Fed will continue to hold rates steady.

While it still certainly possible that the first cut to rates could come in March, but we're still of the mind -- and the Fed may be yet, too -- that core inflation will need to at run below the 3% mark for a while before the first rate cut get serious consideration. Core PCE just cracked this level in December, edging down to a 2.9% annual rate, with the trend over the last six months or so responsible for pulling it down fairly quickly.

Fed's "balance sheet" trends

In addition to raising rates, the Fed is continuing the process of "significantly" reducing its balance sheet and is now trying to retire $35 billion of MBS and $60 billion of Treasury debt from its investment portfolio each month. Higher market-engineered mortgage rates over the last year crushed refinancing, slowed mortgage market activity considerably, and softened housing markets appreciably.

Achieving desired levels of portfolio runoff of mortgage holdings may eventually see the Fed need to conduct outright sales of MBS. With mortgage rates high, home sales slow and refinancing at a virtual standstill, the current rate of MBS runoff was and is highly likely to run below desired levels, and has been since the runoff program began 15 months ago.

The general process of balance-sheet reduction is accomplished by no longer using the proceeds of inbound interest and principal payments from the Fed's existing holdings to buy more bonds. As such, reductions in holdings are happening as borrowers whose mortgages make up those MBS pay down their loan balances, which any homeowner knows is a slow process.

As of January 24, the Fed held $2.428 trillion in mortgage paper, down from $2.707 trillion when the QT program began in June 2022, so the reduction isn't happening at the pace the Fed has hoped. By design, some $682 billion should have been trimmed from Fed MBS holdings by the end of January, but the decline has only been about $279 billion so far, less than half of what the Fed was hoping to see. MBS holdings will decline faster as mortgage rates decline and refinancing activity picks up.

It's not known (the Fed may not even know at this point) what size the balance sheet will need to be in the Fed's "ample reserves" monetary regime. If we assume that the central bank was comfortable with the size of the balance sheet pre-pandemic, this would be total holdings of about $4 trillion, so they would need to achieve about $5 trillion in reduction over some period of time. As of January 24, the total Fed balance sheet was about $7.677 trillion, so there remains a ways to go if the goal is to return to a pre-pandemic level. Mr. Powell noted that the Fed will be discussing balance-sheet management at the Fed's March get-together.

The Fed's next scheduled meeting comes March 19-20, 2024. It is likely to be an important meeting, or at least a well-anticipated one, as there is a potential for the first rate cut of the new cycle to occur, even if it is not yet "likely." Even if a cut doesn't come, the meeting will also feature a fresh update to members' Summary of Economic Projections, and that help describe the path for interest rates this year and beyond.

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 July 26, 2023 was the eleventh increase in the funds rate since 2018, when the Fed last completed a cycle of increasing interest rates. The current 5.5% rate is the highest it has been since January 31, 2001.

By the Fed's recent thinking, the long-run "neutral" rate for the federal funds is perhaps 2.5 percent or so, a level well below what has long been considered to be a "normal" level. The Fed has raised the federal funds rate well above this normal level in order to temper inflation pressures that rose to more than 40-year highs in 2022. Once the Fed cycle of increases is complete, short-term rate may be slow to retreat to the Fed's "long-run" 2.5% rate. As of December 2023, the central bank's own forecast doesn't expect for it to return there until 2027 at the very earliest.

The Fed can either establish a range for the federal funds rate, or may express a single value for its key monetary policy tool.

Related content: Federal Funds Rate - Graph and Table of Values

How does the Federal Reserve affect mortgage rates?

Historically, 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.

After the program of MBS and debt accumulation by the Fed ended, they were still "recycling" inbound proceeds from maturing and refinanced mortgages to purchase replacement bonds for a number of years. This kept their holdings level and provided a steady presence in the mortgage market, which helped to keep mortgage rates steady and markets liquid.

This recycling of inbound funds lasted until June 2017, when the Fed announced that the process of reducing its so-called "balance sheet" (holdings of Treasuries and MBS) would start in October 2017. In a gradual process, the Fed in steps reduced the amount of reinvestment it was making until it eventually was actively retiring sizable pieces of its holdings. When the program was announced, the Fed held about $2.46 trillion in Treasuries and about $1.78 trillion in mortgage-related debt. It had been reducing holdings at a set amount and was on a long-run pace of "autopilot" reductions through December 2018.

HSH.com Federal Reserve Policy Tracking Graph

In 2019, the Fed decided to begin winding down its balance-sheet-reduction program with a termination date of October. With signs of some financial distress showing in financial markets due to a lack of liquidity, the Fed decided to terminate its reduction program two months early.

For that run, the total amount of balance sheet runoff ended up being fairly small, and the Fed was still left with huge investment holdings. At the time, the Fed's balance sheet was comprised of about $2.08 trillion in Treasuries and about $1.52 trillion in mortgage-related debt. Although no longer reducing the size of its portfolio, the Fed began to manipulate its mix of holdings, using inbound proceeds from maturing investments to purchase a range of Treasury securities that roughly mimicked the overall balance of holdings by investors in the public markets.

At the same time, up to $20 billion each month of proceeds from maturing mortgage holdings (mostly from early prepayments due to refinancing) were also to be invested in Treasuries; any redemption over that amount was be used to purchase more agency-backed MBS. Ultimately, the Fed prefers to have a balance sheet comprised solely of Treasuries obligations, and changing the mix of holdings from mortgages to Treasuries as mortgages were repaid was expected to take many years. But these well-considered plans didn't last.

HSH.com Federal Reserve Policy Tracking Graph

Then came COVID-19. In response to turbulent market conditions from the coronavirus pandemic, the Fed re-started QE-style purchases of Mortgage-Backed Securities in March 2020, so not only did the slow process of converting MBS holdings to Treasuries come to a halt, the Fed was again actively buying up new MBS, growing their mortgage holdings. Through October 2021, MBS purchases were running at a rate of $40 billion per month, and any inbound proceeds from principal repayments existing holdings were being reinvested in additional purchases. As economic conditions settled, MBS bond buys were trimmed to $30 billion per month starting in December 2021 and then to $20 billion per month in January 2022 and it was expected that a similar pace of reduction going forward would occur.

Since the Fed's restart of its MBS purchasing program in March 2020, it had by mid-April 2022 added more than $1.37 trillion of them to its balance sheet. Total holdings of MBS topped out at about $2.740 trillion dollars, and the Fed's mortgage holdings had doubled since March 2020.

The Fed has since concluded its bond-buying program. The start of a "runoff" process to reduce holdings was announced at the close of the May 2022 meeting and began in June 2022 Reductions of $17.5 billion in MBS in the first three months of the program increased to $35 billion per month in September 2022, and desired reductions in holdings remain at this pace today, but market redemptions remain well short of this goal.

What is the effect of the Fed's actions on mortgage rates?

Mortgage interest rates began cycling higher well in advance of the first increase in short-term interest rates. This is not uncommon; inflation running higher than desired in turn lifted expectations that the Fed would lift short-term rates, which in turn has lifted the longer-term rates that influence fixed-rate mortgages. Persistent inflation has reinforced this cycle.

The reverse of the above is also true. Mortgage rates decreased considerably from peak levels, as an improved outlook for price pressures, loosening labor market conditions and cooling economic growth all suggest that the Fed's cycle of increases has done its job, and that before long, lower short-term rates will be coming.

Also important for this new cycle, is that the Fed is no longer directly supporting the mortgage market by purchasing Mortgage-Backed Securities (which helps to keep that market liquid). This means that a reliable buyer of these instruments -- and one that did not care about the level of return on its investment -- has left the market.

This leaves only private investors to buy up new MBS, and these folks care very much about making profits on their holdings. Add in a range of risks to the economy -- including such things as the potential for softening home prices and this may make them more wary of purchasing MBS, even at relatively high yields. With the Fed also no longer purchasing Treasury bonds to help keep longer-term interest rates low, the yields that strongly influence fixed mortgage rates also rose, and may also be slower to decline than they have been in recent years.

What the Fed has to say about the future - how quickly or slowly it intends to raise rates or lower rates this year and beyond - will also determine if mortgage rates will rise or fall, and by how much. At the moment, and given the Fed's new long-term policy framework, the path for future changes in the federal funds rate is of course uncertain, but the current expectation is that the eleven increases in the federal funds rate so far are now less likely to be joined by others yet in the current cycle. As such, the coming Fed interest rate cycle should be one of declining rates 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 at near zero until March 2022, but fixed mortgage rates rose by better than three quarters of a percentage point in the months the preceded the March 17 increase. Rates increased amid growing economic strength and a increasing concern about broadening and deepening inflation.

A more recent example also shows the converse effect. The Fed last raised rate in July 2023 held them steady through January 2024. Over that time, mortgage rates rose by, and then declined by, more than a full percentage point. All this change in mortgage rates happened while the Fed stood idly by.

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.

The prime rate usually increases or decreases within a day or two of a change in the federal funds rate.

Related content: Fed Funds vs. Prime Rate and Mortgage Rates

After a change to the federal funds rate, 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. We saw this as recently as 2018; after the ninth increase in the federal funds rate over a little more than a two-year period, economic growth began to stall, inflation pressures waned, and mortgage rates retreated by more than a full percentage point. The most recent episode of declining mortgage rates during the end of 2023 and start of 2024 also demonstrates this point.

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 or holding them steady. 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 our analysis of Federal Reserve Policy and Mortgage Rate Cycles.

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