Federal Reserve policy and mortgage rate cycles

Keith Gumbinger

Interest rates In much of its history, the Federal Reserve has preferred to use its traditional tools to manipulate interest rates and help to speed up or slow down the economy. Over the last two Fed cycles, the central bank has employed some novel approaches that have served to manipulate long-term interest rates and mortgage rates more directly.

Novel monetary policy: QE programs, 2008-2019

Back in 2008, with financial markets seizing up, the Fed began a then-novel approach to manipulating markets, conducting what it called "Large-Scale Asset Purchases", also known as Quantitative Easing. In varying amounts, and in varying programs of varying size and varying duration, the Fed accumulated a lot of Treasury and mortgage bonds to help keep long-term interest rates low and to keep mortgage and Treasury markets liquid. These programs of course had an effect on mortgage rates and availability while they ran, ensuring there was always a ready buyer for these instruments even if investors shunned them.

In October 2014, we came to the end of the Fed's first set of Quantitative Easing programs, processed intended to keep long term interest rates low though the purchase of Treasury bonds and to keep mortgage credit flowing at low rates though the purchase of agency-issued Mortgage-Backed Securities (MBS).

At the time the first program came to a close, purchases of these instruments expanded the Fed's holdings (it's "balance sheet") to about $4.2 trillion. With the process of expansion complete, the Fed continued to "recycle" money into Treasuries and MBS as cash came in from bonds and mortgages that were been paid off or refinanced. As such, the Fed continued to directly influence longer-term market interest rates even after they stopped adding to their holdings.

This reinvestment process was originally expected to end when the Fed first lifted short-term interest rates, which it finally did in December 2015. However, the Fed decided to continue its reinvestment policy for several more years, pointing to cessation when "normalization of the level of the federal funds rate is well under way." A plan to begin to taper reinvestment in a measured fashion was announced in June 2017 and took effect later in the year, and only a minor influence on mortgage rates was expected overall.

The tapering plan began in October 2017, when purchasing of new Treasury bonds was pulled back by $6 billion per month and MBS and agency bonds at $4 billion per month. After 3 months (January 2018), the $6 billion and $4B turned into $12 billion and $8B respectively; come April 2018, this rose to $18B and $12B and in October 2018 ended up at as $30B in reduction in Treasury holdings and $20B of mortgage-related debt retired each month. At its outset, this process was expected to continue for an indeterminate period of time, with balances being reduced until the Fed was comfortable that it had only amount needed to manage monetary policy.

Only two years into a "runoff" process that was expected to continue for perhaps 3 or 4, the Fed changed its plans. While the Fed expected to conduct monetary policy solely using its so-called "administered rates" (federal funds, interest on reserves it holds for banks, etc) it would to be doing so in a climate where banks will be holding an "ample supply of reserves". Such reserve holdings means that the Fed needed to hold a larger-than-expected portfolio in order to ensure that the federal funds target could be maintained in all market conditions.

Until May 2019, the Fed's program of trimming its holdings of Treasury bonds and mortgage-related holdings remained in full runoff mode, with up to $30 billion in Treasuries and $20 billion being retired each month. After that, the Fed began slowing its pace of reduction of Treasury holdings to only $15 billion per month; this smaller monthly reduction terminated in September 2019.

At the same time, the runoff of mortgage-related holdings continued at a maximum of $20 billion per month. With its holdings of Treasuries declining to a less-then-desired level, in October 2019 the Fed began to use inbound principal payments received from MBS holdings to purchase new Treasuries; only MBS redemptions in excess of $20 billion per month were used to purchase more MBS. With mortgage rates rising at the time, refinancing became virtually non-existent in much of 2018 and homebuying became sluggish, so the Fed stopped seeing MBS redemptions above $20 billion.

Although not then meeting their goal to eventually hold only Treasury obligations and no mortgages in its portfolio, the Fed steadfastly held through its QE programs that it would not be an outright seller of MBS into the open market. However, this thinking began to change in that direction over time, and in its March 20, 2019 release, the Fed noted that "...limited sales of agency MBS might be warranted in the longer run to reduce or eliminate residual holdings. The timing and pace of any sales would be communicated to the public well in advance."

Federal Reserve QE and Mortgage Supports 2008-2019 - HSH.com

Novel Monetary Policy: QE Programs 2020-current

After the Great Recession QE (and other) response programs, the Fed would likely have preferred to never again need to use extraordinary monetary policy responses to prop up financial markets. It would likely have simply let its balance sheet slowly transform itself from a mix of Treasuries and mortgage bonds to one solely comprised of Treasuries slowly over time, and seemed on a long-term path for this to occur.

Then, in March 2020, the global COVID-19 pandemic hit, something the world is still dealing with to this day. In short order, economies began shut down across the globe to deal with the spreading virus; investors panicked, selling everything as fast as they could at any price if a buyer could be found. Financial markets were in a mess and there was a significant chance that a new (and perhaps worse) Great Depression would ensue. At the time, the Fed held about $1.37 trillion in mortgage-related instruments.

To address this, the Fed not only slashed interest rates back to near zero, but also quickly restarted bond-buying programs. On March 15, 2020, the Fed announced that "over coming months the Committee will increase its holdings of Treasury securities by at least $500 billion and its holdings of agency mortgage-backed securities by at least $200 billion." Such was the panicky state of financial markets that it ran through these declared amounts in a matter of days, and on March 23, simply stated that "The Federal Reserve will continue to purchase Treasury securities and agency mortgage-backed securities in the amounts needed to support smooth market functioning...". In other words, unlimited QE until markets calmed.

By June 2020, markets had calmed a bit, and the Fed only noted that "over coming months the Federal Reserve will increase its holdings of Treasury securities and agency residential and commercial mortgage-backed securities at least at the current pace." Come December 2020, the Fed set specific purchase goals, noting that it would "increase its holdings of Treasury securities by at least $80 billion per month and agency mortgage-backed securities by at least $40 billion per month."

These bond buys continued until November 2021, when a "tapering" process was put into place. At the time, it was expected that the Fed would gradually reduce purchases by $10 billion per month for Treasuries and $5 billion for mortgages, so that the wind-down process would take about eight months, and the first increase in the federal funds rate would happen sometime after that. Reckoning from the last QE wind-down plan, markets expected to then see a period of reinvestment of inbound proceeds amid a slow rise in short-term rates.

This did not occur. With inflation gaining speed and running well above the Fed's hoped-for levels, the central bank accelerated its tapering process to end months earlier than expected, indicating a sooner increase in the federal funds rate. It also surprised the market by revealing that there would be period of reinvestment process, and that balance sheet reductions would begin soon after the federal funds rate started to be increased.

These reductions will begin in June 2022, first starting with $30 billion per month in Treasury runoff and $17.5 billion in MBS runoff; after three months, come September, these figures will be doubled. In his prepared remarks, Fed Chair Powell noted that "For agency mortgage-backed securities, the cap will be 17.5 billion per month for three months and will then increase to $35 billion per month. At the current level of mortgage rates, the actual pace of agency MBS runoff would likely be less than this monthly cap amount." This seems to imply that outright sales of MBS are more likely sooner rather than later.

Federal Reserve QE and Mortgage Supports 2019-current - HSH.com

"Normal" vs. Novel Fed Cycles

So the last cycle was a novel one as the Fed looked to manage its balance sheet while searching for the appropriate level of short-term interest rates to keep the economy running at a measured pace. This new novel cycle will be different than the last, as it also features inflation running at or near 40-year highs.

During "normal" policy cycles, the Fed makes changes to monetary policy by raising or lowering certain interest rates that it directly controls. Traditionally, these include the federal funds and discount rates, but there are also new tools the Fed employs to lift interest rates, too. These include paying banks to keep funds parked with the Fed (called "Interest On Reserve Balance", or IORB) or though a different, more complex method of swapping Fed-held debt for bank cash holdings (called a "Reverse Repo" agreement).

With "liftoff" from zero for rates now out of the way, it is useful to start to consider where Federal Reserve policy might go in this new novel cycle.

Volume, duration and velocity

Regardless of the tools the Fed uses to get there, interest rates will be elevated over time. The questions are, then, "How much will the Fed lift short-term rates?" (aka "volume"), "How long will it take them to get to their likely peaks?" (aka "duration"), and "How fast will they move them there?" (aka "velocity"). Obviously, for homebuyers, the final question is, "Where will mortgage rates be when higher short-term rates are in place?"

It bears noting that the Fed began its last campaign and starts this one in a very unusual position, since nominal interest rates began the cycle near zero in both cases. It also should be noted that the economy seemed to be particularly sensitive to interest-rate changes in the last cycle, so there is a risk of unintended economic damage if the Fed moves too fast or too far.

Homeowners, homebuyers and those in the mortgage market remember well the effects on the housing and refinance markets in mid-2013, when a spike in mortgage rates happened in the aftermath of then-Fed Chairman Bernanke's comments suggesting that QE would eventually come to a conclusion (the so-called "taper tantrum"). Starting in May 2013, average 30-year fixed rates rose by more than a full percentage point over a 10-week period.

History may or may not have repeated itself, but an absolute bond-market rout from the end of 2021 into the spring of 2022 lifted mortgage rates by more than two percentage points this time, and that before the Fed has made much by way of changes to short-term policy rates.

Changes to the downside

It's fair enough to say that history is likely to be a lousy guide to the future, but it's all we have to go on to make judgments. Since the 1980s, there have been 11 Fed cycles for rates, both up and down. There have been periods of pretty pronounced increases, but decreases have been generally larger; for example, a downdraft from 1989-1992 saw a full 6.75 percent chopped off of the federal funds rate as it shrank from 9.75 percent to 3 percent. Other declines of similar size include a 5.875 percent cut from 1983-1986, and more recently, a 5.5 percent slide from 2000-2003. The most recent significant episode was 2006-2008, with a sizable total decline of 5.125, which at the time left rates at historically low levels. The latest decrease cycle was relatively small, totaling about 2 percentage points overall when rates were pushed back to near zero to help combat the economic effects of the pandemic.

Changes to the upside

So much for the downside of rates. Given that interest rates have generally been declining for 30-plus years since the inflation-fueled rates of the early 1980s, the Fed has arguably had some leeway in raising rates, since many of yesterday's "lows" were still elevated by historical standards. The Fed has exercised somewhat more caution in raising rates when needed, with the largest increase occurring from 2003 lows to 2006 highs, a cumulative increase of 4.75 percent in the funds rate. Other smaller cyclical increases of 3.875 percent (1986-1989), 3.25 percent (1982-1983) and a flat 3 percent in 1992-1993 have also been seen. The most recent completed upcycle (2015-2018) featured a total increase of 2.25 percent before rates were again trimmed. The smallest of the increase bunch was just 1.75 percent from a 1998 low to a year 2000 peak for this very short cycle. We're just starting the beginning of a new upcycle; so far, rates have been increased by about 75 basis points of an yet-unknown total.

Average or typical "volume"

For the last 11 Fed cycles of rates (both up and down) the average cumulative move is 4.125 percent. From the near-zero level where we started this latest cycle of increases, history suggests that when the cycle of raising rates is completed, that this process could leave us with a federal funds rate of about 4.375 percent, all things considered. However, as noted above, the Fed has at times expressed more caution in raising rates than lowering them, or at least limited how far they have gone. In this way, the average upward move for the Fed over the last 11 cycles has been about 3.25 percent, which would leave us with a Funds rate of about 3.375 percent. As we're starting from such a low point, and with it likely that the Fed will want some space to lower rates when the next downcycle begins, we're probably going to see an upcycle for the fed funds rate of perhaps 3.875 percent -- landing us at a nice round 4 percent for the Fed's key policy tool.

Average or typical "duration"

How long will it take the Fed to get us back to that level? Again, history's not likely to be much of a guide, since the Fed will be responding to changes in inflation and economic growth as they come along. Although this new cycle is starting out differently as the Fed plays a bit of catch-up to inflation (something they haven't faced in many other cycles) the central bank has generally preferred -- absent emergencies -- to make policy changes only at its regular FOMC meetings, held every six weeks or so. At times, it has even preferred a slower pace of increase or decrease, only making changes at meetings where an updated Summary of Economic Projections (SEP) has been released (once each quarter).

Right now it looks as though it will be an every-meeting affair for at least a while. The Fed began raising rates at its March 16, 2022 meeting and again at its May 4 get-together, and the Fed Chair has taken pains to let the market know that increases can be expected in June and July, too. The Fed is looking to get the funds rate back to at least a "neutral" level (neither lifting growth or damping it) as quickly as it can before it decides how to proceed from there. To do so, it increased the federal funds rates by 50 basis points in May and signaled similar increases to come in the near future. The May increase was the largest one-time move in more than 20 years.

If the Fed continues to raises rates by 50 basis points at its June and July meetings, the funds rate would then have a current range top of 2 percent, but still have a ways to go to be considered neutral. That said, the Fed is not exactly certain where neutral actually lies; some analysts suggest that it could be perhaps 2.5%, but this would still be well below current inflation. In this cycle, it may be that neutral is considerably higher than 2.5%, so should the Fed hit a 2.5% level by late 2022, it could still take a number of additional rate hikes before this cycle of increases is completed.

The last upcycle for the federal funds rate ran three years before a downcycle began. This upcycle is likely to be of considerably shorter duration -- half that time or less -- and will feature rather more volume as a result.

That said, if the economy is not keeping pace as the Fed raises rates, the process may certainly take longer to get to the final peak rate this cycle. Even then, a 4 percent federal funds rate is considered to be pretty close to "normal", and is historically close to average, so the Fed will probably want to get to this level (or at least close) and do so as quickly as possible.

Average or typical “velocity”

The most recent iterations of the Federal Reserve policy-setting committees have all shown a preference for small changes in the Federal funds rate, usually a quarter-percentage point at a time, with a few half-point (or more) exceptions, most often on the downside.

However, after more than 20 years of increasing rates by no more than a quarter-point at a time, the Fed used a 50 basis point increase in May 2022 and signaled that at least two more similar moves should be expected in June and July. Could they move even more quickly? Certainly, although Mr. Powell said that the rate-setting committee was not "actively considering" hikes of 75 basis points or more. Of course, if inflation continues to have traction and labor markets don't cool as the Fed hopes, it's still possible that larger hikes could come.

At a minimum, we have already seen one 50 basis point hike and at least two more are penciled in for June and July, so the velocity of change this time is already happening at an accelerated pace. It is possible that a burst of these larger rate increases to start the upcycle will give way to a more measured pace of smaller increases to end it, but this remains to be seen.

What will happen to mortgage rates?

Is the history of fairly recent Fed moves any help here at all? Well, the environment in which mortgages are priced today is certainly different than in the past, so the experience taken from those episodes may not be all that helpful. However, the last time we had a federal funds rate at about 4 percent, either precisely at this rate (or rising or falling though it) was in late 2007, and prior to that, November 2005, May 2001 and spring 1994.

The most recent period is arguably most relevant. In late 2007 and early 2008, 30-year fixed mortgage rates slid just below the 6 percent mark, but it is reasonable to say that credit conditions were deteriorating quickly at that point and few investors wanted anything to do with buying mortgages, so that may have kept mortgage rates more elevated than they otherwise might have been.

Still, there was no shunning of mortgages of any means back in 2005, and even though the funds rate was moving in a downward fashion, conforming 30-year fixed rates remained around the 6.25 percent mark, so it may be that this is a "true" or "natural" level for mortgages when the Funds rate is around the 4 percent mark.

Earlier periods are less relevant and certainly provide less comfort. Back in 2001, a 4 percent funds rate was paired with 30-year fixed mortgage rates hanging around 7 percent... and back in 1994, mid-to-upper 8 percent mortgage rates were in play.

Interest-rate relief may be hard to find

When fixed mortgage rates eventually do rise, there will continue to be other options for borrowers, but it may be that borrowers will have to make difficult choices when trying to choose a mortgage. Common Adjustable Rate Mortgages (ARMs) will of course be available in the market, and these may provide a lower-cost option for at least some period of time, while holding out the possibility to borrowers for lower rates in the future. Those looking for considerable interest rate relief will probably be disappointed, though, at least if recent comparisons of the last few times we saw 6 percent 30-year fixed rates holds true.

For example, in early 2008, rates for both 30-year fixed and initial rates for 5/1 ARMs were both just under 6 percent. At the time, investors and lenders were generally shunning mortgages, so there was no aggressive pricing by lenders to provide much by way of discounts on ARMs to mortgage shoppers. In fact, investors and lenders were aggressively marketing mortgages of all stripes back in late 2005 and early 2006, a prior episode of 30-year fixed rates climbing above the 6 percent mark. At that time, the interest rate break for selecting a 5/1 ARM was just a third of a percentage point or less, so there was no real rate relief to be found.

With this the case at the time, it's little wonder that borrowers looking to afford homes with fast-rising home prices felt compelled to consider at the lower monthly payments available on interest-only and Option ARMs to enhance affordability.

Puny spreads between the 30-year fixed rate mortgage (FRM) and 5/1 ARM products have existed at other times, too, so borrowers should not expect to always find the one-percentage point (or more) break we see today. In fact, the average break over the last 20 years is a little more than two-thirds of a percentage point (just 0.67 percent).

With market-based long-term mortgage rates rising much more quickly (so far) than Fed-engineered short-term rates, the difference between conforming 30-year FRMs and 5/1 ARMs is the widest it has been in about eight years. For at least a time, a 5/1 ARM may provide valuable rate relief for borrowers who can handle the risks that an ARM presents.

Wrapping it all up

So, looking forward to the next few years of changing Fed policy, it may take a while to get us back to "normal" for the Federal funds rate. To be fair, 5 and 6 percent fixed-rate mortgages are still historically quite good, but will feel expensive relative to the record-low bottoms and near-bottoms for rates we've become accustomed to during the extraordinary times of the crisis and post-"Great Recession" and Pandemic eras. Regardless of whatever nominal level they ultimately achieve, should mortgage rates become to be perceived as "high", we may see the more of the kind of unintended economic damage to housing noted early on in this article.

The future

All in all, if you're thinking of buying a home in 2022 or beyond, it might be a good idea to use a low-to-mid 5 percent interest rate for 30-year fixed rates in your calculations. Thirty-year fixed mortgage rates ran nearly all the way up to 5% in late 2018, and we've recently surpassed those levels by a little bit; given market conditions, they could peak a fair bit higher than this in the coming months.

If you plan on selling a home on our way to (or at) the next peak of mortgage rates, keep in mind that rising interest rates means affordability for buyers gets crimped, especially if there are no viable lower-cost mortgage products for buyers to turn to when loan costs go up. As such, over time you may not have as much pricing power as you do now, or at other times when mortgage rates are lower.

(Image: travellinglight/iStock)

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kimberly kinseth October 20, 2016 2:57 pm

Ok bear with me but small town actually happened,. Can banks do only mortgages 36 months that ends then loan ends legally as documents state instead bank calls it extentions to first 36 month loan ends to continue interest changes and that's there mortgage loan you can even get extentions then called extention that adds past due payments extended at claimed end of loan that way you can borrow payment you don't have to stay current. They also stated they don't go by interest from prime lending rate last also don't and won't ever provide amortization on any loans don't know how . Also claimed we put down 10,000.00 when we didn't but loaned money to pay cost to get closing cost and attorney fee loaned they use there own attorney ceo owner last lender did appraisal himself to make value 12,000.00 more to have the 80 20 ratial

Editorial Team October 25, 2016 2:47 pm

Kimberly, I can't follow along but it sounds like you need to contact a real estate attorney for help. Thanks for commenting, Tim Manni, HSH.com

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