HSH.com on the latest move by the Federal Reserve

At the close of its late October meeting, the Federal Reserve decided to cut the federal funds rate by another 25 basis points (0.25%), moving the target range for the Fed's key policy tool to 1.5% to 1.75%. This is the third cut in the federal funds rate since 2008, and returns it to where it was in March 2018.

Noting that "business fixed investment and exports remain weak" and that "uncertainties about [the] outlook remain," the Fed decided that "the implications of global developments for the economic outlook as well as muted inflation pressures" were sufficient reason to cut its key short-term rate despite characterizing U.S. economic conditions as fair. "[T]he labor market remains strong and that economic activity has been rising at a moderate rate. Job gains have been solid, on average, in recent months, and the unemployment rate has remained low [and] household spending has been rising at a strong pace."

Although the global economy is beyond the Fed's purview, there is little doubt that the disruption of trade from the imposition and/or threat of tariffs have dinged other developed economies. To be sure, a lower federal funds rate can do little to combat erratic trade policies, but does signal that the world's most important central bank will do what it can to help keep growth going. Growth in China, Germany, Japan, the Eurozone and elsewhere have all downshifted this year, and central banks around the globe have been taking steps to address this sluggishness, mostly by cutting rates.

New Fed Policy Signals

The Fed has been searching for a way to tell markets that is doesn't intend to keep cutting rates indefinitely, and that their latest action coupled with two other "insurance" cuts in the last three months are sufficient to offset the drag from the U.S.-China "trade war". In just the last few weeks, at least a working "truce" in the trade skirmish has kept tariffs on Chinese goods from being increased again, and it may be that a separate planned December increase will be avoided, too. The detente on trade between the two largest economies has improved business optimism to a degree, and with the odds of a Brexit deal in the U.K. on the rise, longer-term interest rates have firmed up off rock-bottom levels.

To subtly signal to investors that they should not expect any additional rate cuts any time soon, the Fed removed a key phrase from its meeting-closing statement. For the last three meetings, the Fed pledged to "act as appropriate to sustain the expansion", but that reference to additional potential rate cuts is gone. Unless economic conditions suddenly worsen there will be no cut in December, and should domestic and global conditions improve, the next move could even be a rate increase, but that's not likely for a good while yet, even if there is broad improvement.

In his post-meeting press conference, Fed Chair Jay Powell's prepared remarks suggest the Fed would prefer to stay on hold, perhaps for a long while, noting that "We [the FOMC] believe monetary policy is in a good place", that "We see the current stance of monetary policy as likely to remain appropriate" and that it might only consider changing policy again "if developments emerge that cause a material reassessment of our outlook".

Although the Fed noted that inflation remains muted, the most recent data for the Fed's preferred measure of prices says otherwise. The "core" measure of Personal Consumption Expenditures had been running at just a 1.1% clip in the first quarter of 2019, moved up to 1.7% in the second, and the latest quarterly review of core PCE (released just prior to the Fed meeting) showed prices rising at a 2.2% clip. This is now a pace above the Fed's 2% target and the fastest increase in core prices since the first quarter of 2018.

With a pretty solid economy in place and core inflation on a firming path, not all FOMC members thought that the funds rate should be cut; the vote was 8-3, with two participants preferring to leave the funds rate untouched.

Other Fed Actions

Two other policy moves were made at the meeting. Along with the reduction in the federal funds rate, the Fed also trimmed the rate it pays to banks for depositing excess reserves, and the IOER rate was moved to 1.55%. The Fed also will continue to recycle inbound proceeds from maturing Treasuries into new purchases of bills, notes and bonds spread along the yield curve, and continues its program of reinvesting inbound payments on mortgages and mortgage-related debt up to $20 billion per month in new Treasuries. Anything over this redemption amount will be recycled for purchases of more agency and MBS debt. High refinancing activity may see this overage buying happen as the year progresses, providing a least a little support to keep mortgage rates low.

While the Fed signaled a likely pause in cutting rates, the reaction by markets was muted. Just after to the meeting, federal funds futures markets placed only about a 20% chance of another rate cut in December and only about a one-in-three chance for a cut in January. With the next meeting, we'll get a fresh update to the Summary of Economic Projections (SEP), which will also provide a sense of where Fed members think policy will be in 2020 and beyond. If they believe that these three rate cuts (and actions by other central banks) will start to lift the global economy, we could see some upward tilt to their expectations for the likely direction of inflation and interest rates.

The Committee's official statement that closed the meeting was of course vague in this respect, though, and said only that "The Committee will continue to monitor the implications of incoming information for the economic outlook as it assesses the appropriate path of the target range for the federal funds rate."

If labor markets continue to remain strong with reasonably solid hiring each month and hold a near-50-year low unemployment rate while core PCE inflation edges higher, we think any investors betting on another rate cut anytime soon are likely to be disappointed Mr. Powell's comments seem to make this a virtual certainty for at least the time being.

The next FOMC meeting comes December 10-11.

On a longer-term basis, it looks as though that this particular Fed interest-rate cycle has at least paused (if not altogether ended) with rates well below historic norms. Expectations for the federal funds rate in the September Summary of Economic Projections (SEP) indicate that Fed members see a long-run rate (post-2022) of just 2.5%. The current expectation for this year is now at 1.9%, and the outlook suggests a steady stance at that level in 2020 before rates begin to be lifted again in 2021. The next updated SEP comes with the December meeting.

With the latest move of the federal funds rate putting it in a range of 1.5 percent to 1.75 percent, the larger cycle of interest rate increases are done, for now, but perhaps so is the mid-cycle adjustment for rates, too. Whether or when the upcycle for rates will resume is unclear at the moment. That said, with long-run projections for the funds rate now above today's levels, it should be noted that the Fed's 2.5% forecast for the longer run isn't necessarily the peak possible interest rate over time, but rather an annual average that may be tempered by future conditions, where rates have started moving down as a result of a worsening 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 last Fed move on October 30, 2019 was the third decrease in the funds rate since 2008, when the Fed moved the rate to nearly zero. As Fed Chairman Powell characterized the July 2019 move as a "mid-cycle adjustment", it's not clear whether this is a temporary retreat in a still-ongoing cycle of increases or the latest cut may also be followed up with additional cuts, although those not look increasingly unlikely. The Fed would of course never rule out cutting rate if believed that it was warranted, but is currently providing no indication at all that it intends to do so anytime soon.By the Fed's current thinking, the long-run "neutral" rate for the federal funds may be as low as 2.5 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?

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.

Earlier this year, 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 August 1, all inbound proceeds from maturing investments will be 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) will also 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 general, the Fed will continue to be a buyer of newly-issued Treasury debt, which should keep some downward pressure in overall interest rates, but will generally not be a buyer of MBS, so what happens to mortgage rates will again be more fully at the whims of investors in these securities. Of course, the Fed can certainly change balance-sheet policies in the future, as warranted.

Some analysts reckoned that the original expected program of divestiture/runoff of Treasuries and mortgages would make fixed-rate mortgages perhaps a quarter percentage point higher than they would otherwise have been in "normal" market conditions. With the program terminating early and with the Fed remaining a considerable buyer of Treasuries and perhaps mortgages (at times), this new phase of the Fed's balance-sheet management program is expected to have only a modest direct damping effect on mortgage rates,

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

For this cycle, and for the moment, more important than any small change in the overnight rate is that the Federal Reserve is no longer actively increasing its holdings of Mortgage-Backed Securities (MBS) and Treasuries. Presently, it is in the process of converting MBS holdings into Treasuries as they mature and replacing maturing mortgages with new purchases if loan redemptions exceed $20 billion per month. With the Fed gradually working off its mortgage holdings, the effects of this process should eventually lift mortgage rates somewhat, and private investors will have to pick up increasing amounts of these bonds.

With an unexpected decline in mortgage rates happening in 2019, refinance activity has again kicked higher and home sales have firmed a little bit of late, so there may be some additional bond supply that investors will need to absorb, which may help to firm rates at some point. That said, the supply of new MBS remains fairly low, helping temper expected increases in mortgage rates.

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. After a period of drawing down its holdings, the Fed is again actively recycling inbound proceeds from its holdings into new purchases of Treasuries, and possibly mortgages if market conditions warrant. The resumption of the reinvestment program means that a large regular buyer of these instruments will be a regular presence in the market. While a stabilizing factor, 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; even with the first declines in more than 10 years breaking a string of nine rate increases in July 2019, the future for monetary policy is very murky at the moment and there is certainly no unanimity in thinking among Fed policy makers as to their future direction.

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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