Last market hits the finish line! A final update for HSH's Home Price Recovery Index.

Last market hits the finish line! A final update for HSH's Home Price Recovery Index.

HSH.com on the latest move by the Federal Reserve

A change is coming. That was the message from the statement that closed the September 22, 2021 Federal Reserve meeting.

There was no change to policy at this meeting; none was expected. However, investors have been looking for additional clues as to the timing and pace of the tapering of purchases of Treasury bonds and Mortgage-Backed Securities, and some more explicit (yet still vague) details were revealed in the statement that closed the meeting and in the subsequent press conference with Fed Chair Jay Powell.

The statement didn't provide any specific time as to when bond buying would start to be reduced. However, it noted: "Last December, the Committee indicated that it would continue to increase its holdings of Treasury securities by at least $80 billion per month and of agency mortgage-backed securities by at least $40 billion per month until substantial further progress has been made toward its maximum employment and price stability goals. Since then, the economy has made progress toward these goals. If progress continues broadly as expected, the Committee judges that a moderation in the pace of asset purchases may soon be warranted." (emphasis ours)

"Soon" likely means that an outline for tapering will be revealed at the November 2-3 meeting and will start later in the month or in December.

In his post-meeting press conference, Chair Powell indicated that he expected the tapering process to come to completion in mid-2022, so the tapering process would start and end in about 6-8 months. With such a timeline, it's reasonable to expect that Treasury bond buying would be tapered by $10 billion per month and MBS by $5 billion per month; if started in December, the process would be complete by the end of July. Of course, this timeline could be sped up if it appears that conditions warrant, but the Fed in the past has shown a preference for a measured pace of reductions.

The Fed has made it clear that it wants to complete the tapering well in advance of the timing of "liftoff", also known as the first increase in the federal funds rate. Mr. Powell again took pains to note that the tests and goals for tapering and those for increasing interest rates are wholly separate and distinct, but noted that in his view, the "substantial further progress" tests for tapering have largely been met, and that he would only like to see perhaps one more solid hiring report to be satisfied. At the same time, he expressed that some of the other Fed members believe that the goals to allow for tapering to begin have already been achieved.

Indications are that a growing number of Fed meeting participants expect to be lifting short-term rates next year. In July, 7 of 18 members contributing their outlooks in the Summary of Economic Projections thought there would be at least one rate hike in 2022; that figure is now 9, increasing the likelihood that such a move will come. Six expect a single quarter-point move; three expect two increases in the federal funds rate before the year is out. Given the expressed desire to have tapering complete before rates move higher, this suggests an increase at next September's meeting and perhaps another in December 2022.

The SEP also suggests that the pace of increases in short-term rates is expected to quicken thereafter. For 2023, all but one of 18 expect at least one hike to be in place, and a majority expect the federal funds rate to be at about the 1% level or higher, so perhaps 3-4 additional hikes in rates are expected. By 2024, there's little consensus as to where short-term rates might be; forecasts range from 0.625% to as high as 2.625% but center around 1.75% to 2% by that time.

Although the official expectation is that the current run-up in prices will prove transitory, the Chair did note that the Delta variant may be exerting some new pressures on already messy supply lines, and that could produce more durable price pressures than was expected just a few months ago. The SEP reflected this, with the 2021 forecast for the core PCE price measure the Fed prefers ratcheted up from 3% in June to 3.7% now, a level nearly double the Fed's desired limit. Expectations for higher prices in the future were pushed higher, too, with forecasts of core PCE rates of 2.3% next year and 2.2% in 2023. Both figures were raised relative to June's SEP outlook.

Mr. Powell noted that the Delta surge dented growth over the summer and likely has tempered an expected upswing in hiring this fall. Members outlooks for GDP growth were trimmed from a heady 7% for 2021 to 5.9%, and with little more than three months left in the year there's little chance of a huge spike in growth that might kick that figure higher. At the same time, expectations for falling unemployment rates are also now more measured, with unemployment expected to hit 4.8% by year's end, up from 4.5% just three months ago. Still, even 4.8% would mean considerable hiring in September and the next three months, since the "official" unemployment rate was 5.2% through August.

That the economy has been improving for some time is a given at this point; annualized GDP growth in the second quarter was 6.6%, a robust pace. Current reckoning for the third quarter (about half the data is in already) points to a 3.7% rate for GDP, although forecasts are still calling for about a 5% rate for the period. Delta, again was the proximate cause for the slowing: "The sectors most adversely affected by the pandemic have improved in recent months, but the rise in COVID-19 cases has slowed their recovery", noted the Fed.

As would be expected, the Fed once again reiterated "The Federal Reserve is committed to using its full range of tools to support the U.S. economy in this challenging time, thereby promoting its maximum employment and price stability goals."/p>

Before the April 2021 meeting, Fed officials essentially revealed that they won't consider changing interest rate policies until the economy is near full employment as measured by a range of observations, that core PCE inflation is holding at or above a 2% annual level and seems likely to hold there, and that longer-range inflation expectations remain tethered near that 2% core PCE rate. Although enough progress has been made to start to wind down extraordinary and emergency-level programs such as QE-style bond buying, and there is sufficient evidence to conclude that the Fed's goals for inflation have not only been met but exceeded, it may be a while before the "full employment" component of their dual mandate is judged to be reached. Before the pandemic hit, labor markets were the best in some 50 years, with unemployment at 3.5%, and the central bank is determined to try to get back to those levels.

Currently, The Committee expects to maintain an accommodative stance of monetary policy until these outcomes [maximum employment and average 2% core inflation] are achieved. The Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and expects it will be appropriate to maintain this target range until labor market conditions have reached levels consistent with the Committee's assessments of maximum employment and inflation has risen to 2 percent and is on track to moderately exceed 2 percent for some time."

The next scheduled FOMC meeting will occur on November 2-3, 2021.

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 March 15, 2020 was the fifth decrease in the funds rate since 2008, when the Fed last moved the rate to nearly zero. Before the pandemic outbreak, three quarter-point cuts in the key overnight lending rate were characterized by Fed Chairman Powell as a "mid-cycle adjustment", with the first of the total of five reductions coming in July 2019 and later accompanied by two additional "insurance" cuts in the federal funds rate. These moves were intended to offset the effects of a "trade war" between the U.S. and China and other nations. After the last of the three moves in October 2019. the Fed said that it expected to hold rates level for the foreseeable future. This of course began to change as the coronavirus pandemic increasingly disrupted economic activity, when the Fed added a half-point and then full-point cut in rates in short succession in March 2020.

By the Fed 's recent thinking, the long-run "neutral" rate for the federal funds may be as low as 2.5 percent, a level well below what has long been considered to be "normal" levels. As such, even if rates do rise over time, they may not get close to historic "normal" levels anytime soon.

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 trimmed 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.

In 2019, 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 was 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 in August 2019, all inbound proceeds from maturing investments were being 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) were also to 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 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 has again been actively buying up new MBS, expanding their mortgage holdings for at least a time. The current rate of outright purchases is $40 billion per month, and inbound proceeds from principal repayments on holdings and refinancings are also being reinvested. Since the Fed restarted their MBS purchasing program again in March 2020, it had by late mid-September 2021 added more than $1.129 trillion of them to its balance sheet, with total holdings of MBS now topping $2.514 trillion dollars.

The Fed is also again buying Treasury securities across the term spectrum at a rate of $80 billion per month. Any purchases of 10-year debt will help produce downward pressure on the yields that most influence fixed mortgage rates.

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

For this new cycle, more important than any change in the overnight intrabank lending rate is that the Federal Reserve is continuing to increase its holdings of Mortgage-Backed Securities (MBS) and Treasuries. Having an active buyer in the market who will purchase these investments regardless of yield will help to keep mortgage rates more steady and likely at lower rates than would otherwise be the case if just private investors were the only market participants.

With mortgage rates recently and repeatedly hitting new "all-time" record lows there has been a surge in refinancing activity, so there will likely be a lot of new and lower-yielding bonds for the Fed to absorb as we move deeper into 2021 and beyond. Of late, downward pressure on mortgage rates will increase supplies of MBS to a degree, but there will still be plenty of Treasury debt for the Fed to absorb.

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 (reinvestment), keeping its portfolio at a constant size. The new actions means that holdings will again be expanding, and while this is a stabilizing factor for the market, 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 2021 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 uncertain, but the current expectation is that it may be a year or more before the Fed again considers lifting the federal funds rate, if then. With rates pegged near zero again, monetary policy looking forward may look a lot like that we saw at times in the early to mid stages of the record-long economic expansion, which is to say on hold for an extended period.

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 our analysis of Federal Reserve Policy and Mortgage Rate Cycles.

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