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With the Income You Need to Buy a Median-Priced Home rising - you may need to Learn About Adjustable Rate Mortgages to preserve affordability.

With the Income You Need to Buy a Median-Priced Home rising - you may need to Learn About Adjustable Rate Mortgages to preserve affordability.

HSH.com on the latest move by the Federal Reserve

Keith Gumbinger

As expected, the Federal Reserve doubled down on its largest single increase in the federal funds rate since 1994, with another 75 basis point increase pushing the key monetary policy rate to a range of 2.25% to 2.5%, the highest it has been in about three years. Another increase of some amount is likely yet to come in September, but after that, the path becomes less clear.

Since the Fed's last meeting in June, inflationary pressures have gotten no better, with the widely-followed Consumer Price Index now at a full 9% annual rate, the highest level in more than 40 years. Even though the economy is starting so show at least mixed signs of slowing, the Fed still "anticipates that ongoing increases in the target range will be appropriate", at least until rates get to a "modestly restrictive level", according to Fed Chair Jerome Powell.

At his post-meeting press conference, the Fed Chair was frequently asked whether or not the economy was in recession or heading toward one. Pointing to the tight labor market and other indicators, Chair Powell indicated that he didn't think the economy was in a recession at the moment, and that there still remains a path for the central bank to engineer a soft landing, where growth slows but doesn't significantly reverse and employment levels remain high.

There isn't really a simple definition of recession -- the official arbiter, the Business Cycle Dating Committee of the National Bureau of Economic Research uses a range of indications to make its call -- but a popular (if simplified) reference is when GDP growth is negative for two consecutive quarters. With a -1.6% rate for the first quarter of this year (said to be caused by trade and inventory-accumulation changes) and with a current run rate for the second quarter pegged at -1.2% by the Atlanta Fed's GDPNow model (and likely slowing for more conventional reasons) there's a good likelihood that more pronounced slowing in the economy is stating to show, whether it is technically in a recession or not.

Slower growth and lessening demand to attenuate inflation is what the Fed is after. If a modest downturn for a while is required to get inflation trending in the right direction, it appears that, while the Fed doesn't prefer this outcome, it is prepared to at least tolerate it for a time.

The latest increase in the federal funds rate won't be the last in this cycle. Chair Powell indicated that the current level for the federal funds rate is "in range of neutral", although there's not a great consensus of exactly what the neutral rate actually may be. The expectation still remains that the Fed will look to move the federal funds rate to perhaps 3% to 3.5% by the end of the year.

While the Fed declined to provide the kind of specific "forward guidance" it offered at each of the last two meetings, Chair Powell suggested that another "unusually large move" was still a possibility at the September meeting, although the committee was closer to again operating on a meeting-to-meeting basis for adjusting policy. At the same time, the Fed Chair noted that "As the stance of monetary policy tightens further, it likely will become appropriate to slow the pace of increases while we assess how our cumulative policy adjustments are affecting the economy and inflation." As such, if the Fed intends on moving policy to a "modestly restrictive level", a half-point move in September followed by a quarter-point move in either November or December seems to be the most likely forward path at the moment.

Of course, changes in monetary policy and associated "tightening of financial conditions" affect the real economy with a unknown time lag, and with the Fed moving very quickly from near-zero to near-normal policy, there is still quite a lot of yet-unrealized economic drag in the pipeline.

In addition to raising rates, the Fed is continuing the process of "significantly" reducing its balance sheet, retiring $17.5 billion of MBS and $30 billion of Treasury debt each month, amounts that will double come September. Higher market-engineered mortgage rates this year have crushed refinancing, slowing mortgage market significantly, and housing markets are also softening quickly. This means that there are fewer new mortgage-backed securities (MBS) that investors need to absorb, so even with a large buyer (the Fed) stepping out of the market mortgage rates have mostly leveled off of late, even finding opportunities to decline meaningfully at times. Regardless, the inflation situation will continue to drive the bulk of any additional rate increases for the summer and beyond. So far, the process of the Fed stepping away from directly supporting the mortgage market hasn't been all that disruptive; we'll see whether this continues to be the case when September gets closer and a faster pace of reduction kicks in.

Hoped-for levels of runoff of mortgage holdings may eventually see the Fed 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 likely to run below desired levels No mention of outright sales was made in the official statement, and it is very likely that we'll not hear much about this until later in the year at the earliest.

The general process of balance-sheet reduction is accomplished by no longer using the proceeds of inbound interest and principal payments from holdings to buy more bonds. As of July 13, the Fed held $2.709 trillion in mortgage paper, down from a recent peak of $2.740 trillion, so the gentle reduction is just getting underway. This is more than double the amount it held pre-pandemic, and its total balance sheet is just about $8.9 trillion.

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.

At the stated pace of reduction, trimming off $5 trillion from the balance sheet might take close to five years -- about 51 months of Treasury reductions will carve $3 trillion off the total, and about 58 months of MBS reductions would shave off $2 trillion. This would still leave around $715 billion in MBS; however, the Fed has also stated that it prefers to ultimately hold only Treasury obligations, so the MBS reduction plan will probably be increased to $50 billion per month at some point and include outright sales to reach that level. At $15 billion per month of additional sales, it will take about 48 months to reduce MBS holdings to zero, and if it was to happen concurrently with runoff would need to start not more than about 10 months from June, or sometime in April 2023.

Of course, this is all speculation on our part. More likely is that the balance sheet ends up larger than the pre-pandemic $4 trillion, and that some kind of "proceeds of MBS sales will be used to buy Treasuries" kind of arrangement will happen to help change the mix more quickly. We'll know more in the months ahead, but for now, the process will begin in a measured, predictable fashion.

The Fed's "dual mandate" sees it perpetually seeking stable prices in the context of full employment. The Fed considers a broad range of labor-market indicators, from measures of unemployment, wage and benefit cost changes, labor force participation and others. The pandemic has created considerable upheaval in the labor force, with millions of workers still not engaged in the workforce jobs despite record levels of job openings and rising wages. Retirements, COVID concerns, child- and family-care issues and a range of increased government supports are probably all playing a role here, making it a challenge for the Fed to know what "full employment" might actually be, but most indicators suggest we are fairly close.

That there are literally millions more jobs available than workers who are interested in filling them gives the Fed rather a bit of leeway to lift interest rates and look to cool demand without grave concerns that unemployment will kick higher quickly. More likely, as financial conditions tighten, these "excess" job openings will first disappear as aggregate demand is tempered, bringing into better balance the supply of and demand for labor. This is the Fed's hope, and a key component of any "soft landing" they hope to achieve.

The Fed is also concerned with external events that impact economic growth and inflation, although there's nothing that the Fed can do to change them. The statement noted "The war and related events are creating additional upward pressure on inflation and are weighing on global economic activity." Interestingly, the committee removed the previous statement's reference to COVID-19 lockdowns in China exacerbating supply-chain issues, although they don't seem to have abated very much.

The Fed's next scheduled meeting comes September 20-21, when there will be a fresh update to the FOMC's Summary of Economic Projections.

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 June 27, 2022 was the fourth increase in the funds rate since 2018, when the Fed last completed a cycle of increasing interest rates.

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, and perhaps even quickly, they may not get close to historic "normal" for a while yet.

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 was making in steps 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.

HSH.com Federal Reserve Policy Tracking Graph

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, and 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 was be used to purchase more agency-backed MBS. Ultimately, the Fed looked to have a balance sheet comprised solely of Treasuries, but changing the mix of holdings from mortgages to Treasuries as mortgages are repaid was expected to take many years.

HSH.com Federal Reserve Policy Tracking Graph

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 for at least a time. Through October 2021, the current rate of outright purchases was $40 billion per month, and inbound proceeds from principal repayments on holdings and refinancings are also being reinvested. MBS bond buys will be trimmed to $30 billion per month starting in December 2021 and to $20 billion per month in January; a similar pace of reduction going forward is expected. Since the Fed restarted their MBS purchasing program again in March 2020, it had by mid-January 2021 added more than $1.32 trillion of them to its balance sheet, with total holdings of MBS now topping $2.740 trillion dollars. The Fed's MBS holding have doubled since March 2020.

The Fed has now concluded its latest bond-buying program. The start of a "runoff" program to reduce holdings was announced at the close of the May 2022 meeting and commenced in June 2022 Reductions of $17.5 billion in MBS in the first three months of the program will double to $35 billion per month thereafter.

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.

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 economic climate may make them more wary of purchasing MBS, particularly at relatively low yields. At the same time, the Fed is no longer purchasing Treasury bonds to help keep longer-term interest rates low, and so the influential yields on these instruments have risen somewhat as a result.

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 first three increases in the federal funds rate will be joined by several others in the current cycle.

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 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

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