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HSH.com on the latest move by the Federal Reserve

At the close of its late April-early May 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's latest statement regarding policy seemed a little more terse than usual, noting that the "labor market remains strong and that economic activity rose at a solid rate. Job gains have been solid, on average, in recent months, and the unemployment rate has remained low."

Although the initial assessment of GDP growth in the first quarter showed an annual rate of 3.2%, the breadth of growth was rather thin, and the Fed's statement reflected this with "Growth of household spending and business fixed investment slowed in the first quarter." Growth for the period was goosed by an inventory buildup and a short-term boost in exports, items that probably won't be repeated in the second quarter or beyond.

Hitting a desired level of inflation continues to vex the Fed. "On a 12-month basis, overall inflation and inflation for items other than food and energy have declined and are running below 2 percent," and in fact, measures of inflation have actually retreated of late. Low and fading inflation make it unlikely that the Fed will look to life interest rates anytime soon, and in fact, should inflation continue on a downtrend, increases the chance that a cut in rates may be in the cards sooner rather than later. That said, those betting on a rate cut may end up being disappointed, as Chairman Jay Powell said that with regard to inflation trends that “[The FOMC] suspects transitory factors may be at work."

How real is the chance of a cut? Federal funds futures markets presently reckon about a 20% probability of a cut at the June meeting, and greater than a 60% chance of at least one cut by the time December rolls around. Of course, there is a lot of year yet to go and these probabilities will change along as new data on prices become available.

The Fed's program of trimming its holdings of Treasury bonds and mortgage-related holdings remains for now in full runoff mode, but changes are afoot there as well. Starting in May, the Fed will continue 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. Then, starting in May, the rate of reduction of Treasury holdings will be halved, falling to a reduction of not more than $15 billion per month, and this smaller reduction will terminate in September.

The runoff of mortgage-related holdings will continue at a maximum of $20 billion per month. However, beginning in October 2019, principal payments received from these holdings up to $20 billion will in turn be invested new Treasuries; any excess will continue to be used to purchase more MBS. With refinancing virtually non-existent and homebuying sluggish, the Fed hasn't been seeing redemptions above $20 billion very often for quite a while, although some recent refinancing activity has seem them cross this mark at least once this year. Overall, there will likely be only a limited effect in terms of keeping mortgage rates low.

The next FOMC meeting comes June 18-19. 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.

For what it's worth, we think that we will see some economic improvement as the year progresses. If the data improves as we expect, the chances of at least one rate hike this year will also rise. We'll know more by the time the spring comes to a close, so the June Fed meeting is one we are focused on at this point.

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 2.75% to 3%, which would be about a percentage point lower than history would suggest.

With the last 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 and may be nearly complete at this point. With long-run projections still somewhat above today's levels, it should be noted that the 2.75% to 3% rate forecast for the longer-run isn't necessarily 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 last 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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