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Wondering about where mortgage rates are headed? Check out our latest Two-Month Mortgage Rate Forecast.

HSH.com on the latest move by the Federal Reserve

Keith Gumbinger

With inflation starting to behave a little bit and significant previous rate hikes yet to be fully realized across the economy, the Federal Reserve lifted it's key policy rate again today, but in a smaller, half-point increment this time. This lifted the federal funds rate to a range of 4.25% to 4.5%, its highest level since October 31, 2007, although at that time, this rate was in the process of being lowered as the financial market crisis began to spread.

The statement released at the close of each meeting usually contains a summary characterization of overall conditions. It noted that "Recent indicators point to modest growth in spending and production," unchanged from both September's and November's note, and the wording of the latest statement was virtually unchanged from November.

The Fed has been cheered by inflation readings that have improved in recent months. The Consumer Price Index has settled from an annual reading of 9% in June to 7.1% for November; core CPI has been stickier, easing from 6.7% annual as recently as September to 6% last month. Sliding energy prices has helped the overall headline figure to decline, but they aren't included in the core reading.

The November update to the Fed's preferred measure of inflation hasn't been released yet, but should follow the same pattern as the CPI. PCE prices have been slower to retreat; while overall PCE prices have eased from a 7% annual rate in June to 6% in October, core PCE prices -- the ones the Fed closely follows -- peaked (so far) at 5.4% in March, dipped to 4.7% by July, then re-flared back to 5.2% for September. October showed a new hopeful easing, coming in at a flat 5%, and November will probably slip below 5%

The new Summary of Economic Projections from Fed members points to a 4.8% core PCE to close 2022; for next year, a material decline of 1.3 percentage points to a 3.5% rate is forecast, but core PCE isn't currently expected to be back to where the Fed wants it until 2025. This expectation suggests that monetary policy will need to remain restrictive over a longer period of time, exerting enough drag on the economy to reduce price pressures slowly.

The precise percentage level of inflation really doesn't matter just yet. What matters is that core PCE remains about 2.5 times the level the Fed wants to see, and in Fed Chair Powell's words, they will want to see "substantially more evidence" that inflation is moving slowing toward its 2% goal. This will take some time; Mr. Powell noted, with supply chains improving and consumer demand shifting back toward services, that goods inflation is retreating as expected, helping inflation ease. As well, he noted that the housing-cost related component of core PCE is expected to drop considerably by the middle of next year, so another inflation component will diminish. However, the Fed Chair took pains in his press conference to note that labor markets remain too tight and wage gains are inconsistent with 2% inflation at the moment. Since "services outside of housing" make up 55% of core PCE inflation, and this is largely made up of labor costs and wages, it is likely that core inflation will remain higher than the Fed desires until labor conditions ease considerably.

The statement noted: "Job gains have been robust in recent months, and the unemployment rate has remained low", also an echo of the previous statement. However, the new SEP from Fed members suggests that loosening will be coming next year, as the unemployment rate is expected to rise from 3.7% this year to 4.6% sometime next year and remain there throughout 2024 before falling slightly after that.

The Fed is hoping to loosen the labor market without causing a recession and throwing a lot of folks out of work. To do so, overall consumer demand will need soften, the number of job openings will need to shrink and the number of folks who want to work at jobs that are available needs to increase. There's little consensus as to whether or not the Fed can achieve this "soft landing" for the economy, and it's own forecast puts the unemployment rate (currently 3.7%) at 4.6% by the end of next year. Such a large increase in the unemployment rate has never occurred outside of a recession, so the challenge for the Fed is considerable. It does appear that the Fed would tolerate a modest economic downturn if required to get inflation trending in the right direction and more under control.

The latest increase in the federal funds rate won't be the last in this cycle. The current rate for the federal funds may now be moderately restrictive, but "The Committee anticipates that ongoing increases in the target range will be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time."

The Fed's new projections for the "terminal rate" for the federal funds was moved up by about 75 basis points to a median of about 5.1% for 2023. In reality, the range for this rate would be one of 5% to 5.25%, so at least a few more hikes in rates are coming in 2023. What's not clear is how fast or how many; currently, there's a good chance of at least another 25 basis point move at the end of January (and possibly 50), which would leave just a single 25 basis point increase or two for the remainder of the year. Whether the forthcoming rate hikes come in sequence or will be spread out isn't yet clear, but there is no indication that the Fed intends to pause anytime soon.

Changes in monetary policy and associated "tightening of financial conditions" affect the real economy with a unknown time lag. In short order, the Fed has moved its key policy rate rapidly from near-zero to a moderately tight policy stance, so there is still quite a lot of yet-unrealized economic drag in the pipeline to come. In the weeks leading up to this meeting, financial conditions actually loosened a bit, with mortgage and other long-term rates falling measurably and stock prices increasing, among other signals. Mr. Powell said that "it's important that overall financial conditions continue to reflect the policy restraints that we are putting in place [...] but our focus is not on short-term moves but persistent moves [...] we're not at a sufficiently restrictive policy stance yet."

In addition to raising rates, the Fed is continuing the process of "significantly" reducing its balance sheet and is now retiring $35 billion of MBS and $60 billion of Treasury debt from its investment portfolio each month. Higher market-engineered mortgage rates this year have crushed refinancing, slowing mortgage market significantly, and housing markets are also softening quickly.

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 slowing and refinancing at a virtual standstill, the current rate of MBS runoff was highly likely to run below desired levels, and has been since the runoff program began almost six months ago.

The general process of balance-sheet reduction is accomplished by no longer using the proceeds of inbound interest and principal payments from 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 December 7, the Fed held $2.658 trillion in mortgage paper, down from a recent peak of $2.740 trillion in April, so the reduction isn't happening at the pace the Fed has dictated -- $157.5 billion should have been trimmed by now, but the decline has only been about $69 billion so far, less than half of what the Fed was shooting for.

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.

The Fed is also concerned with external events that impact economic growth and inflation, although there's nothing that the Fed can do to change them. The statement again noted "The war [in Ukraine] and related events are contributing to upward pressure on inflation and are weighing on global economic activity."

The Fed's next scheduled meeting comes January 31-February 1, 2023. There won't be an updated Summary of Economic Projections released at that meeting, so we'll need to wait all the way until March to get an update on the Fed's thinking about the future.

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, 2022 was the seventh increase in the funds rate since 2018, when the Fed last completed a cycle of increasing interest rates.

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. As such, even as rates do rise over time, and perhaps even quickly, they may not get close to historic "normal" level for a time yet.

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 a gradual process, the Fed trimmed back the amount of reinvestment it was making in steps 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 as recently as 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. In August 2019 the Fed 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 was left with a huge set of investment holdings, which at the time comprised of about $2.08 trillion in Treasuries and about $1.52 trillion in mortgage-related debt. At the time, the Fed began changing its mix of holdings, using inbound proceeds from maturing investments to purchase Treasury securities of various maturities to roughly mimic the overall balance of holdings by investors.

At the sale 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 looked to have a balance sheet comprised solely of Treasuries, but changing the mix of holdings from mortgages to Treasuries as mortgages were repaid was expected to take many years.

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, expanding their mortgage holdings. Through October 2021, the running rate of outright purchases of MBS was $40 billion per month, and inbound proceeds from principal repayments on holdings and refinancings were also being reinvested in additional purchases. MBS bond buys were trimmed to $30 billion per month starting in December 2021 and then to $20 billion per month in January and it was expected that a similar pace of reduction going forward would occur.

Since the Fed restarted their MBS purchasing program again in March 2020, it had by mid-April 2022 added more than $1.37 trillion of them to its balance sheet, and total holdings of MBS topped out at about $2.740 trillion dollars. The Fed's MBS 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 reductions in holdings remain at this pace today.

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, and will until short-term rates are raised high enough to slow the economy and cool price pressures.

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 who care very much about making profits on their holdings, and a range of risks to the economic climate may make them more wary of purchasing MBS, particularly at relatively low yields. At the same time, the Fed is no longer purchasing Treasury bonds to help keep longer-term interest rates low, and so the influential yields on these instruments have also risen somewhat as a result.

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, 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 six increases in the federal funds rate so far may be joined by several others yet in the current cycle.

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.

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 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.

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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