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HSH.com on the latest move by the Federal Reserve

At the close of its late January meeting, the Federal Reserve decided to make no change in the current level for the federal funds rate, leaving the target range for the Fed's key policy tool of 2.25% to 2.5% in place. This is the highest such level since early 2008.

In making no change to the rate, the Fed noted that "the labor market has continued to strengthen and that economic activity has been rising at a solid rate." (The last characterization said "strong" rather than solid, a tacit acknowledgment that the economy cooled a bit in the fourth quarter of 2018. The central bank went on to say "Household spending has continued to grow strongly, while growth of business fixed investment has moderated from its rapid pace earlier last year", a passage unchanged from the December statement of six weeks ago.

With inflation holding near the Fed's target there was little new to be said, but it Fed statement noted that "On a 12-month basis, both overall inflation and inflation for items other than food and energy remain near 2 percent. Although market-based measures of inflation compensation have moved lower in recent months, survey-based measures of longer-term inflation expectations are little changed."There was rather a bit of change in the central bank's stance as it pertains to broader economic issues. In December, a component of the statement read "The Committee judges that risks to the economic outlook are roughly balanced, but will continue to monitor global economic and financial developments and assess their implications for the economic outlook."

With growth in China, Germany and the Eurozone all slow or slowing, with a messy Brexit process making headlines daily and inflation readings all coming in on the softer side, they took the opportunity to provide context as to why rates could remain steady, saying "In light of global economic and financial developments and muted inflation pressures, the Committee will be patient as it determines what future adjustments to the target range for the federal funds rate may be appropriate to support [stable inflation and low unemployment]."

In recent weeks, that Fed has taken pains to emphasize that it would employ patience in its approach to raising rates, and also that it would likely be more flexible in adjusting the pace at which it is depleting its holdings of bonds and mortgage backed securities. In December, the official Fed stance was that "some further gradual increases in the target range for the federal funds rate" were likely in the future; this "forward guidance" was full omitted from the latest statement.

In a special statement that accompanied the close of this meeting, the Fed essentially codified a flexible approach for its balance-sheet normalization process; in it, the Fed said that while it prefers to use the federal funds rate as it's primary policy tool, that "The Committee is prepared to adjust any of the details for completing balance sheet normalization in light of economic and financial developments" and that it would be "prepared to use its full range of tools, including altering the size and composition of its balance sheet, if future economic conditions were to warrant a more accommodative monetary policy than can be achieved solely by reducing the federal funds rate."

All this said, it is not clear when the next move by the Fed can be expected. Futures market peg the probability of an increase in the federal funds rate at just over 1% chance by the close of the March meeting and only about an 8% chance by June.

The updated forward-looking projections proved in December suggest perhaps 1-2 additional increases in the funds rate in 2019 and possibly another 1-2 again in 2020. Should these forecasts come true, the fed funds rate would peak at perhaps 3.5 percent or slightly below for this cycle.

The Fed's program of trimming its holdings of Treasury bonds and mortgage-related holdings remains for now in full runoff mode. The Fed's plan to reduce its balance sheet will see a $30 billion per month reduction in Treasury holdings and a $20 billion per month in MBS and agency debt; it will continue this pace of reducing holdings going forward for an indeterminate period of time. The Fed has not made it known (and may itself not yet know) how low it will eventually let its holdings become, but Fed Chairman Powell has seemed committed to letting the runoff continue until perhaps 2021.

So far, the effect on interest rates has been muted, but given low issuance of new MBS amid a firm interest rate climate, it is likely that they aren't even hitting these caps with any regularity. To date, the Fed's overall balance sheet has only been reduced modestly; as far as mortgages go, MBS holdings have been trimmed from about 1.78 trillion to about 1.63 trillion since the program began. The Fed has stated that it will not institute outright sales of bonds to achieve its balance sheet reduction goals, and given current and expected mortgage market conditions, the pace of reduction may be glacial.

The next FOMC meeting comes March 19-March 20. Although the Fed can change policy at any time, it has for years shown a preference to only make changes when their meeting is accompanied by updated FOMC member projections for growth, inflation and monetary policy. However, Fed Chairman Powell now holds press conferences after every meeting to discuss the FOMC's action (or not), so there is an increased likelihood that at some point we will see a move in the federal funds rate even at a meeting that does not feature updated projections. That said, we think the Fed may make its next move at a meeting that does include projections, but perhaps not in March, depending on inbound economic data.

On a longer-term basis, it still may be that this Fed interest-rate cycle will end with rates well below historic norms. Projections for the federal funds rate over the "longer run" (beyond 2021) envision the key short-term policy rate averaging perhaps 3 percent, which would be about a percentage point lower than history would suggest. However, and based on member projections, there are some inklings that this ceiling isn't cast in stone; for example, the long-range forecast moved down from 3.0% to 2.8% with the December 2018 update. Of course, we have a ways to go yet to get to even 3 percent, let alone averaging it for an entire year.

With this move of the federal funds rate putting it in a range of 2.25 percent to 2.5 percent, the cycle of interest rate increases likely is well more than three-quarters completed at this point. By a wide majority, all member projections put the funds rate above the projected 2.8 percent "longer run" level as soon as September 2019; it should be noted that this isn't the peak possible interest rate, but rather an annual average that may be tempered by future conditions where rates have started moving down as a result of a worsening economic climate. Indeed, the projections suggest that peak rates may come in 2020 or 2021 and could begin to decline thereafter.

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 latest Fed move on December 19, 2018 was the ninth increase in the funds rate since 2006, and continues what is expected to be a protracted "tightening cycle" for interest rates, the first such cycle since 2004. At that time, the Fed embarked on a campaign which featured increases in the overnight rate for 17 consecutive meetings, and 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 long-run "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.

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.

In June 2017, the Fed announced that the process of reducing its so-called "balance sheet" (holdings of Treasuries and MBS) would start in October 2017. In this gradual process, 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 at the time of the announcement 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.

Some analysts reckon that the program of divestiture/runoff 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 has stepped away from actively and directly supporting the mortgage market though purchases Mortgage-Backed Securities (MBS) and Treasuries. The effects of this process will eventually lift mortgage rates somewhat, and private investors will have to pick up increasing amounts of these bonds. So far, a marked slowing of refinancing activity and only modest levels of home sales has meant that there aren't as many new bonds being issued as were expected, so there has been no oversupply of bonds for investor to absorb. The limited new supply of MBS has helped temper expected increases in mortgage rates.

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 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 2019 and beyond – will also 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.

HSH.com Federal Reserve Policy Tracking Graph

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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