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It's a question almost everyone is asking: "Should I refinance my mortgage?" If so, what's the best way to pay for my mortgage refinance

It's a question almost everyone is asking: "Should I refinance my mortgage?" If so, what's the best way to pay for my mortgage refinance

HSH.com on the latest move by the Federal Reserve

The Fed is in no hurry to make any changes to monetary policy, and from their own reckoning about the future of economic growth, inflation and the likely path for the federal funds rate won't be making any moves for a good long while yet.

"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" read the lead sentence from the latest statement after the close of the two-day meeting, a repeat of a message that first appeared nearly six months ago when the coronavirus pandemic was upending financial markets and the broader economy.

However, there was a bit of optimism expressed, too, as the Fed noted that "Economic activity and employment have picked up in recent months but remain well below their levels at the beginning of the year." The July statement said "picked up somewhat", so this is a bit of an acknowledgement that the economy is moving at a faster pace of late. After a truly brutal second quarter, where GDP contracted at a historic rate, we are likely to see a significant rebound for the third quarter, with current estimates putting growth during the period at an annual rate of better than 30 percent.

The the economy is capable of such a rebound is impressive, and has been fostered in part by both Federal Reserve policies of low rates and liquid financial markets as well as significant fiscal stimulus earlier this year. Federal Reserve officials have been prodding Congress to add even more fiscal stimulus to tide over the most economically vulnerable, but warring political factions in an election year seem unlikely to be able to come to any useful compromise or agreement. As such, the timing or even existence of a new fiscal kick is uncertain.

New for this meeting is the incorporation of the Fed's new long-term policy framework. Released to the public back on August 27, the Fed has essentially abandoned its former policy of a symmetrical 2 percent inflation target for a more flexible regime; should it's preferred measure of price inflation (core PCE) run below 2 percent for a time, the Fed will allow it to rise above this level for a time as compensation. Officially, the Fed said that it "seeks to achieve inflation that averages 2 percent over time" and that "following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time."

What's not clear just yet (and is probably still under discussion) is both how much higher would be allowed to climb and how long it will be allowed to remain above the target level before the Fed would pull the trigger on a rate hike. As we are a fair bit away from the target and have been for a while, there's little to be concerned with at the moment, but once inflation approaches and crests over the mark, investors will want to know what comes next, and how soon.

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 Fed also again pledged to "increase its holdings of Treasury securities and agency mortgage-backed securities at least at the current pace to sustain smooth market functioning and help foster accommodative financial conditions, thereby supporting the flow of credit to households and businesses."

Released with this meeting came the quarterly update on Federal Reserve members Summary of Economic Projections (SEP). In graphics, this reveals each FOMC members' expectations about economic growth, inflation and the potential level o of the federal funds rate over near term, medium term and longer term periods. Across the board and in aggregate, the SEP for September was measurably improved over the June outlook. In June, for example, growth for all of 2020 was expected to be a -6.5%; this was pushed up to a much-less-dire -3.7% in September, but forecasts for growth in 2021, 2022 were pulled down a little individually, but the long-run outlook for 2023 and beyond were improved a bit.

Expectations for unemployment levels this year and in the coming years were reduced considerably, but the forecast of a 4% level of joblessness for 2023 is still not back to where it was recently as February, and with the Fed's new framework in place, it's hard to know what unemployment rate they might consider to be "full employment" in the context of potentially increasing rates. However, inflation expectations were lifted a little bit in each of the three previously forecasted years (2020, 2021, 2022) and it is not until 2023 that the Fed expects core PCE inflation to even return to 2 percent, let alone pass this level.

With "full employment" a long way distant from today and with core inflation expectation suggesting years before the target is reliably reached, it's little wonder that the members policy forecast was a flatline, with all participants expecting no change to the federal funds rate in 2020 or 2021, just one member expecting a lift in policy in 2022 and just four in 2023. Longer run, they are optimistic that policy will eventually return to "normal" with the funds rate at about 2.5 percent. We could be looking at mid-late decade for that at the earliest. However, opinions and forecasts change over time, and just as members' outlooks improved from June to September, they may improve again, and the wildcard in all of this is the virus itself and of course any prospects for (or implementation of) a vaccine, which would change the picture immensely. Will we know more about a vaccine in December when the next SEP is released? Maybe.

The next scheduled FOMC meeting will occur on November 4-5, 2020. We'll have the first official estimate of third quarter GDP at that point, may or may not have a new fiscal stimulus plan in place and there is no telling what will become of the normally nice, orderly presidential election process. With the change in inflation-targeting policy and the long, flat outlook for the federal funds rate, the Fed has bridged the contentious election season and it is possible that we may not even see a change in the funds rate covering the next administration, whenever the victor may be decided.

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. Originally characterized by Fed Chairman Powell as a "mid-cycle adjustment", the first of the five reductions came in July 2019 and was 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 will trim 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 will be 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.

As noted above, the Fed has now re-started QE-style purchases of Mortgage Backed Securities, so not only has the slow process of converting MBS holdings to Treasuries come to a halt, the Fed will again be actively buying up new MBS, so their holdings of mortgages will again be expanding for at least a time.

The Fed will again be buying Treasury securities across the term spectrum, and any purchases of 10-year debt will help to help 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 again increasing its holdings of Mortgage-Backed Securities (MBS) and Treasuries. Having an active buyer in the market who will purchases 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 (if perhaps temporarily) 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 2020. [To start, for the monthly period that runs through April 13, 2020, the Fed expects to purchase around $80 billion in agency MBS, which will include $23 billion in purchases to reinvest principal payments from agency debt and agency MBS expected in the month of March.]

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 2020 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 uncertain, and per the Fed's own words will be dictated by emergent conditions and forming trends. With the recent move to 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.]

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 Federal Reserve Policy and Mortgage Rate Cycles ."

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