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Wondering where mortgage rates are headed as we approach spring? See our latest Two-Month Forecast for mortgage rates

Wondering where mortgage rates are headed as we approach spring? See our latest Two-Month Forecast for mortgage rates

HSH.com on the latest move by the Federal Reserve

At the close of its mid-December meeting, the Federal Reserve decided to make no change in the current level of the federal funds rate, which remains tethered to a range of 1.5% to 1.75%. The key policy rate is holding at a level last seen in March 2018.

Although again citing that "business fixed investment and exports remain weak", the Fed stood pat, focusing instead on the positives, noting that "Economic activity has been rising at a moderate rate. Job gains have been solid, on average, in recent months, and the unemployment rate has remained low." In addition "household spending has been rising at a strong pace".

Since the FOMC last met in October, there have been at least some encouraging signs on the issues that have most impacted growth around the world. Importantly, the U.S. and China are said to be actively hammering out a "Phase One" trade agreement, and it also looks as though the replacement for NAFTA (called the USMCA) is also likely to get put in place before long. The economy is running at a moderate 2% clip in the second and third quarters and looks poised for much the same in the fourth, so it would appear as though the concerns about spreading economic malaise from the various trade and tariff impasses have not been realized, at least so far.

Tomorrow, the UK votes on a new Parliament, and that will help to determine what comes next for the Brexit process. If Prime Minister Johnson wins and holds a majority, odds favor a speedier Brexit, as the PM has pledged to get a deal in place by January 31. Should Jeremy Corbyn's party prevail, the process may be delayed and could include a "confirming" referendum for the people to vote on. One way or the other the process is moving along more quickly than at any time since 2017.

Reviewing the Summary of Economic Projections made available after the close of the meeting, it appears as though the Fed expects to have policy on hold for a good while. The so-called "dot plots" in the SEP from the 17 FOMC members show that 13 of them think there will be no change to the federal funds rate in 2020, and just four think that there could be one increase. For the moment, and possibly the foreseeable future, "The Committee judges that the current stance of monetary policy is appropriate to support sustained expansion."

Unless economic conditions suddenly worsen there will be no cut anytime soon, and should domestic and global conditions improve, the next move could even be a rate increase, but that's not likely for a good while yet, even if there is broad improvement. In discussions and speeches, the Fed has made it plain that it is willing to tolerate faster growth and even higher-than-preferred inflation for a time before it would consider raising rates, and we would need to see several quarters of data reflecting this before a move would be considered. As well, it is likely that the Fed will want to see signs of improvement not only here in the U.S. but also in other developed economies before making any move.

Although the Fed noted that inflation remains muted ("overall inflation and inflation for items other than food and energy are running below 2 percent"), the most recent data for the Fed's preferred measure of prices says price pressures remain firm, if below target. The "core" measure of Personal Consumption Expenditures had climbed up to a 1.7% annual rate in the second quarter and settled to 1.6% for the third. Other measure of costs such as the core CPI suggest a steady rate of prices as well, if at a somewhat higher level.

The vote to leave the federal funds rate unchanged was 10-0. Previous meetings had seen some dissent, but it looks as though all voting members are now in accord.

There were no other policy changes at the meeting, but the Fed will continue to recycle inbound proceeds from maturing Treasuries into new purchases of bills, notes and bonds spread along the yield curve, and continues its program of reinvesting inbound payments on mortgages and mortgage-related debt up to $20 billion per month in new Treasuries. Anything over this redemption amount will be recycled for purchases of more Mortgage-Backed Securities. High refinancing activity since mid-year has supported this overage MBS buying as the year progressed, and new mortgage buys have totaled about $33 billion over the last six months. In turn, this has provided a little support to keep mortgage rates low.

While the Fed signaled a pause in cutting rates, this was largely expected, so the reaction by markets was muted. Just after the meeting, federal funds futures markets placed only about a 9% chance of a rate cut in January and only about a 35% for a cut by June's meeting.

The Committee's statement that closed the meeting provided no explicit clues to the FOMC's thinking, simply saying that the committee "will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments" in determining the timing and size of future adjustments to the target range for the federal funds rate.

The next FOMC meeting comes January 28-29, 2020.

On a longer-term basis, it looks as though that this particular Fed interest-rate cycle has at least paused (if not altogether ended) with rates well below historic norms. Expectations for the federal funds rate in the December Summary of Economic Projections (SEP) indicate that Fed members see a long-run rate (post-2022) of just 2.5%. The current expectation for this year is now at 1.6%, and the outlook suggests a steady stance at that level in 2020 before rates begin to be lifted again in 2021. The next updated SEP comes with the March 17-18 meeting.

With the latest move of the federal funds rate putting it in a range of 1.5 percent to 1.75 percent, the larger cycle of interest rate increases are done for now, but perhaps so is the mid-cycle adjustment for rates, too. Whether or when the upcycle for rates will resume is unclear at the moment. That said, with long-run projections for the funds rate now above today's levels, it should be noted that the Fed's 2.5% forecast for the longer run isn't necessarily the peak possible interest rate over time, 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.

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 October 30, 2019 was the third decrease in the funds rate since 2008, when the Fed moved the rate to nearly zero. As Fed Chairman Powell characterized the July 2019 move as a "mid-cycle adjustment", it's not clear whether this is a temporary retreat in a still-ongoing cycle of increases or the latest cut may also be followed up with additional cuts, although those look increasingly unlikely. The Fed would of course never rule out cutting rates if believed that it was warranted, but is currently providing no indication at all that it intends to do so anytime soon.By the Fed's current thinking, the long-run "neutral" rate for the federal funds may be as low as 2.5 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?

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.

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. 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 as recently as December 2018.

Earlier this year, the Fed decided to begin winding down its balance-sheet-reduction program with a termination date of October, but as of August 2019 decided to stop reducing its holdings altogether, ending the program two months early. As the total amount of balance sheet runoff was fairly small, the Fed will be left with a huge set of investment holdings, presently comprised of about $2.08 trillion in Treasuries and about $1.52 trillion in mortgage-related debt. Starting August 1, all inbound proceeds from maturing investments will be used to purchase more Treasury securities of various maturities to roughly mimic the overall balance of holdings by investors. As well, up to $20 billion each month of proceeds from maturing mortgage holdings (mostly from early prepayments due to refinancing) will also be invested in Treasuries; any redemption over that amount will be used to purchase more agency-backed MBS. Ultimately, the Fed wishes to have a balance sheet comprised solely of Treasuries, but changing the mix of holdings from mortgages to Treasuries as mortgages are repaid will take many years.

In general, the Fed will continue to be a buyer of newly-issued Treasury debt, which should keep some downward pressure in overall interest rates, but will generally not be a buyer of MBS, so what happens to mortgage rates will again be more fully at the whims of investors in these securities. Of course, the Fed can certainly change balance-sheet policies in the future, as warranted.

Some analysts reckoned that the original expected program of divestiture/runoff of Treasuries and mortgages would make fixed-rate mortgages perhaps a quarter percentage point higher than they would otherwise have been in "normal" market conditions. With the program terminating early and with the Fed remaining a considerable buyer of Treasuries and perhaps mortgages (at times), this new phase of the Fed's balance-sheet management program is expected to have only a modest direct damping effect on mortgage rates,

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

For this cycle, and for the moment, more important than any small change in the overnight rate is that the Federal Reserve is no longer actively increasing its holdings of Mortgage-Backed Securities (MBS) and Treasuries. Presently, it is in the process of converting MBS holdings into Treasuries as they mature and replacing maturing mortgages with new purchases if loan redemptions exceed $20 billion per month. With the Fed gradually working off its mortgage holdings, the effects of this process should eventually lift mortgage rates somewhat, and private investors will have to pick up increasing amounts of these bonds.

With an unexpected decline in mortgage rates in 2019, refinance activity has again kicked higher and home sales have firmed a little bit of late, so there may be some additional bond supply that investors will need to absorb, which may help to firm rates at some point. That said, the supply of new MBS remains fairly low, helping 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. After a period of drawing down its holdings, the Fed is again actively recycling inbound proceeds from its holdings into new purchases of Treasuries, and possibly mortgages if market conditions warrant. The resumption of the reinvestment program means that a large regular buyer of these instruments will be a regular presence in the market. While a stabilizing factor, 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 or lower rates in 2020 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 uncertain, and per the Fed's own words will be dictated by emergent conditions and forming trends. At the moment, monetary policy looks to be on a flat, slow path, but of course this can change.

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. 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.

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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