In a widely expected move, the Federal Reserve decided today to lift the federal funds target rate by a quarter of a percentage point. The new range for the overnight cost of money between banks now stands at 0.75 percent to 1 percent, the highest this benchmark has been since late October 2008.
Despite a second increase in just three months' time, the Fed noted that "The stance of monetary policy remains accommodative", even as "the labor market has continued to strengthen and that economic activity has continued to expand at a moderate pace."
The Fed's members also updated their summary of economic projections and outlook for interest-rate policy. There was only a small change in the expectation for core Personal Consumption Expenditure price inflation, which is now expected to be at 1.8 percent come December 2017, up from 1.8 percent reckoned when the December 2016 meeting closed. The Fed acknowledged this, noting that "Inflation increased in recent quarters", but one change to consider is that they now believe that price pressures are "moving close to the Committee's 2 percent longer-run objective."
The latest projections for interest rate policy show that a majority of members expect that just two more interest rate hikes will take place this year. This soothed financial markets, who we starting to worry about a more aggressive pace of hikes in the days leading up to the meeting. Financial markets were cheered by the prospect of lower rates for longer, and underlying interest rates that influence mortgages have eased somewhat.
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 December 14, 2016 was the second 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.
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 will continue its program of buying Mortgage-Backed Securities (MBS) and Treasuries. 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 termination of the program means that a large regular buyer of these instruments has stepped out of the market, so at times there may be more supply than demand for MBS. In turn, this will tend to lift mortgage rates to a degree.
What the Fed has to say about the future – how quickly or slowly it intends to raise rates in 2017 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 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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