With a recent flare in longer-term interest rates doing some of its heavy lifting, the Federal Reserve decided today to hold the federal funds rate steady at a range of 5.25% to 5.5%. This kept the key policy rate's at its highest level since late January 2001.
It's not clear if July's increase was the last for this cycle, but it is true that the Fed has slowed its cadence of rate hikes. After 10 consecutive meetings of lifting rates, the Fed skipped a single meeting back in June, then increased rates in July, but has now held short-term rates level for two meetings in a row.
"Recent indicators suggest that economic activity expanded at a strong pace in the third quarter," noted the statement the closed the November 1 meeting. Not all that long ago, Fed Chair Powell said in a prepared speech that "Additional evidence of persistently above-trend growth [...] could put further progress on inflation at risk and could warrant further tightening of monetary policy." Economic growth rang in at 4.88% annualized rate in the third quarter, but it's too soon to tell if a more subdued pace is forming for the fourth quarter.
The Fed continues to point to progress being made on inflation, but the downtrend for price pressures has slowed of late. The Fed's preferred gauge -- Personal Consumption Expenditure prices -- has come down measurably from peak levels, but on an annualized basis has settled at 3.4% in each of the last three months. Core PCE (a measure the central bank believes to be the best indicator of inflation trends) has also retreated considerably from peak levels, but the rate of decline has been modest of late at best. Despite progress, it is running at a 3.7% annual rate through September, still close to twice the Fed's target, and more-intractable service costs have been somewhat firmer over the last three months.
Still, progress is progress, and the Fed would likely rather endure a protracted period of gradually slowing prices amid solid growth and labor markets rather face than sharper declines accompanied by recession and faltering job markets. Still, "Reducing inflation is likely to require a period of below-potential growth and some softening of labor market conditions," noted Chairman Powell in his prepared remarks.
In the release that accompanied the close of the meeting, the Fed's statement regarding price pressures remained terse, as it has for some time now: Simply, "Inflation remains elevated."
Tight labor markets are also on the Fed's mind, of course. The statement noted that "Job gains have moderated since earlier in the year but remain strong, and the unemployment rate has remained low." While the October employment report doesn't come until a couple of days after we've written this, the last three months have seen very strong hiring that accelerated over the summer months; after a July dip, job openings rose smartly in August and increased a bit more in September, and layoffs and voluntary separations have been low. The unemployment rate did lift off a recent bottom, but has held at a very low 3.8% in each of the last two months. Wage and other compensation growth has been settling slowly, at least compared to last year and earlier this one, but the Employment Cost Index for the third quarter was a little higher than the second, so labor costs remain pretty firm at the moment.
There were no additional clues as to whether or not there will be another increase in the federal funds rate anytime soon. The statement said that "The Committee will continue to assess additional information and its implications for monetary policy," and that "In determining the extent of additional policy firming that may be appropriate to return inflation to 2 percent over time the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments."
Odds of additional Fed rate increases
Per Fed Chair Powell, the Fed now sees policy as "restrictive", but that doesn't mean it can't or won't increase rates again if the data suggests another hike is warranted.
With this in mind, the July 2023 increase in the federal funds rate may not be the last in this cycle. Although it may be restrictive, the current level for the federal funds rate may or may not be sufficient to drive inflation back down to the 2% "core" PCE goal the central bank has set. Even absent any additional hikes, it is likely that this key rate will remain elevated for a fair period of time, perhaps a year or more.
The most recent (September) update of the Summary of Economic Projections (SEP) reveals this. Fed members still to expect that another hike in the federal funds rate before the end of 2023 remains on the table, as the median projection for the key monetary policy rate remained at 5.6%, a level about a quarter-point higher than today's 5.25% to 5.5% target range.
At the same time, the "higher rates for longer" expectation now looks increasingly likely. In June, members projected that they would be cutting rates by a full percentage point by the end of 2024; now, only a half-point reduction is forecast. Expectations for the downward trajectory over 2025 and beyond hasn't changed -- a 1.2% decline in rates expected -- but it is now forecast to be starting from a higher nominal level, and the federal funds may not approach its long-run level of 2.5% until 2027 or beyond.
The September SEP also reflected views that core PCE inflation will be a little lower at the end of the year than was than expected in June, while the outlook for inflation in 2024 and beyond remained about as it was three months ago, falling to 2.6% by years' end. Economic growth is expected to generally be stronger over the next year than was forecast three months ago, while the unemployment rate is forecast to be lower than the prior outlook, and not expected to exceed 4.1% over the next few years. Unemployment is currently a pretty tight 3.8%, and compared to other rate-hike cycles, an upward trend for joblessness to only 4.1% would be quite mild.
There is one more Fed meeting this year in the middle of December. Futures markets presently place about a 20% chance that an increase may come in December, and that probability rises to28% by the end of the January 2024 confab. The incoming data between now and then will have much to say about whether or not the Fed's on-again, off-again pattern of lifting rates will continue, or whether "off again" will hold further into the future. Should they lift rates in December (when the next SEP is due) then hold three months, it would mark a return to a more familiar Fed pattern, where rate changes (if any) occur in conjunction with an updated SEP, a cadence employed in the Fed's 2015-2018 campaign of lifting rates.
One factor that would affect any decision is if the government should be shut down. While a government closure was averted back in September, the issue was only kicked down the road until this month. Appropriations and budgeting to keep the government running -- and collecting and releasing data -- aren't in place yet, but need to be by November 17. Any closure would impact he availability of fresh data, and limit the Fed's visibility into economic and inflation trends.
Fed's "balance sheet" trends
In addition to raising rates, the Fed is continuing the process of "significantly" reducing its balance sheet and is now trying to retire $35 billion of MBS and $60 billion of Treasury debt from its investment portfolio each month. Higher market-engineered mortgage rates over the last year crushed refinancing, slowed mortgage market activity significantly, and softened housing markets appreciably, and there are starting to be signs that home values have or are declining in some areas.
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 and is highly likely to run below desired levels, and has been since the runoff program began 15 months ago.
The general process of balance-sheet reduction is accomplished by no longer using the proceeds of inbound interest and principal payments from the Fed's existing 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 October 25, the Fed held $2.463 trillion in mortgage paper, down from a peak of $2.740 trillion in April 2022, so the reduction isn't happening at the pace the Fed has dictated. Some $542.5 billion should have been trimmed from Fed MBS holdings by the end of this October, but the decline has only been about $277 billion so far, only about half of what the Fed was hoping to see by now.
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's next scheduled meeting comes December 12-13, and there will be a fresh update to members' Summary of Economic Projections released at the close of that meeting. Economic and inflation data out between now and then will be the determining factor as to whether or not another rate hike comes in 2023.
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 July 26, 2023 was the eleventh increase in the funds rate since 2018, when the Fed last completed a cycle of increasing interest rates. The current 5.5% rate is the highest it has been since January 31, 2001.
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. The Fed has raised the federal funds rate well above this normal level in order to temper inflation pressures that rose to more than 40-year highs in 2022. Once the Fed cycle of increases is complete, short-term rate may be slow to retreat to the Fed's "long-run" 2.5% rate. In September 2023, the central bank's own forecast doesn't expect for it to return there until 2027 at the very earliest.
The Fed can either establish a range for the federal funds rate, or may express a single value for its key monetary policy tool.
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.
This recycling of inbound funds lasted until June 2017, when 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 in steps reduced the amount of reinvestment it was making 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.
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 amid some signs of stresses in financial markets.
The total amount of balance sheet runoff ended up being fairly small, and the Fed was still left with a huge set of investment holdings. At the time, this was comprised of about $2.08 trillion in Treasuries and about $1.52 trillion in mortgage-related debt. While no longer reducing the overall amount of its portfolio, 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 same 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, and changing the mix of holdings from mortgages to Treasuries as mortgages were repaid was expected to take many years.
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 2022 and it was expected that a similar pace of reduction going forward would occur.
Since the Fed's restart of its MBS purchasing program in March 2020, it had by mid-April 2022 added more than $1.37 trillion of them to its balance sheet. Total holdings of MBS topped out at about $2.740 trillion dollars, and the Fed's mortgage 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 desired reductions in holdings remain at this pace today, but market redemptions remain well short of this goal.
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 economy -- including such things as softening home prices may make them more wary of purchasing MBS, even at relatively high yields. With the Fed also no longer purchasing Treasury bonds to help keep longer-term interest rates low, the influential yields on these instruments have also risen, and may be slower to decline than they have been in recent years.
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 ten increases in the federal funds rate so far may yet be joined by others yet in the current cycle, even if such increases become sporadic.
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.
The prime rate usually increases or decreases within a day or two of a change in the federal funds rate.
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.
