The Federal Reserve decided today to lift the federal funds rate by a quarter of a percentage point, with the new range for the key benchmark interest rate set at 1.75 to 2 percent.
It is the highest federal funds rate level since September 2008.
In making the move, the Fed upgraded its characterization of the economy, noting "the labor market has continued to strengthen and that economic activity has been rising at a solid rate." ("Solid" was "moderate" in the last two such descriptions). Other economic improvement was acknowledged in "Recent data suggest that growth of household spending has picked up, while business fixed investment has continued to grow strongly." Back in May, the statement noted a moderating trend for household outlays, so it would seem the economy has shifted to a higher gear in the second quarter compared to the first.
The Fed changed its messaging regarding the inflation outlook. Although the review of price pressures again reiterated "On a 12-month basis, both overall inflation and inflation for items other than food and energy have moved close to 2 percent. Indicators of longer-term inflation expectations are little changed, on balance", the Fed omitted a statement about where the market see inflation, as "Market-based measures of inflation compensation remain low" disappeared. As such, it would appear that price pressures are creeping in a bit into investor thinking and that they are adjusting their stances accordingly.
By their policy outlooks for this year, Federal Reserve members are nearly evenly split as to whether there will be a two more rate increases this year or only one. Of the 15 member projections, 8 expect at least two more hikes in the key overnight target rate; 7 expect one move or less. The updated projections also suggest perhaps 4 additional moves in 2019 and 2 again in 2020. Should these forecasts come true, the fed funds rate would peak at perhaps 3.5 percent or slightly above for this cycle.
Starting in July (and holding through September), the Fed's program of trimming its holdings of Treasury bonds and mortgage-related holdings accelerates again. When the month turns, the Fed's plan to reduce its balance sheet will see an $24 billion per month reduction in Treasury holdings and a $16 billion per month in MBS and agency debt in July, August and September, when a greater pace of reductions kicks in, the final leg of the plan. So far, the effect on interest rates has been muted, but given low issuance of new MBS amid a rising interest rate climate, it is likely that they aren't even hitting these caps with any regularity. To date, the Fed's balance sheet has only been reduced slightly; as far as mortgages go, MBS holdings have been trimmed from about 1.78 trillion to about 1.73 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 may be glacial.
The next FOMC meeting comes July 31-Aug 1. As this forthcoming meeting will not feature updated projections for growth and policy and a regular press conference is scheduled, there is a lessened chance of a change to the federal funds rate at that time. However, this is changing; Chairman Powell has indicated that there will be press conferences after every meeting to discuss the FOMC's action (or not), so this suggests a less-predictable pattern of policy moves as rates move closer to traditional norms.
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 2020) envision the key short-term policy rate averaging perhaps 2.9 percent, which would be a percentage point or so lower than history would suggest. However, and based on member projections, there are some inklings that this low ceiling is beginning to rise a bit, but we have a way to go yet to get to even 2.9 percent at the moment. With today's move of the federal funds rate to a range of 1.75 percent to 2 percent, the cycle of interest rate moves may be close to or even more than halfway completed at this point. By a wide majority, all member projections put the funds rate well above the projected 2.9 percent "longer run" level as soon as 2019, so it should be noted that this isn't the peak possible interest rate, but rather an average that is tempered by future conditions where rates have started moving down as a result of a poorer 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 latest Fed move, on June 13, 2018 was the seventh increase in the funds rate since 2006, and continues what is expected to be a protracted "tightening cycle" for interest rates, the first 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 "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.
In 2017, the Fed "recycled" more than $142 billion of MBS; if the plan was already in place, perhaps a third of these would have needed to be absorbed by private investors, which might have lifted mortgage rates a marginal amount. Some analysts reckon that when the program is fully underway it 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 begun to step 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.
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 tapering and eventual 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 2018, 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.
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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