Up for the quarter, down for the year? See what's happening with home affordability in our latest "Income you need to buy a home in the top 50 metro areas".

Up for the quarter, down for the year? See what's happening with home affordability in our latest "Income you need to buy a home in the top 50 metro areas".

HSH.com on the latest move by the Federal Reserve

Keith Gumbinger

Again stating only that "Inflation remains elevated," the Federal Reserve decided today to lift the federal funds rate by a quarter percentage point to a range of 5% to 5.25%, its highest level since June 29, 2006. The last time the federal funds rate was higher than the current level was late January 2001.

Chief among emergent concerns for the central bank is how the recent banking-sector failure and stressors affect the availability of credit, particularly to small and mid-sized businesses. While the Fed had some fresh information on credit availability from the May Senior Loan Officer Opinion Survey, it has not year been released to the public. With regard to the climate for credit and whether the banking system faces more potential issues, the meeting-closing statement noted "The U.S. banking system is sound and resilient. Tighter credit conditions for households and businesses are likely to weigh on economic activity, hiring, and inflation. The extent of these effects remains uncertain." While there are still concerns, Chair Powell noted at his post-meeting press conference that banking conditions "broadly improved since March."

Even as they are still lifting interest rates, the Fed may be nearing or perhaps even at the end of its rate-hiking campaign.

Until the February 1 statement, the Fed noted that "ongoing increases in the target range will be appropriate" to bring inflation under control. The March statement modified and softened this position, stating "that some additional policy firming may be appropriate." [emphasis ours] This latest statement didn't rule out the possibility of additional rate hikes, but didn't make them seem imminent, either. The statement merely read "In determining the extent to which additional policy firming may be appropriate to return inflation to 2 percent over time, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments" [again, emphasis ours]. In short, an additional hike or hikes may be needed, but the data will inform whether or not one comes. Mr. Powell noted that "a decision [by the Committee] to pause was not made today."

The statement released at the close of each meeting usually contains a summary characterization of overall conditions. This meeting's seemed quite terse: "Economic activity expanded at a modest pace in the first quarter. Job gains have been robust in recent months, and the unemployment rate has remained low."

Noting only that "Inflation remains elevated," the Fed didn't provide much color as to whether it thinks the steps it has taken so far will ensure future progress toward tempering prices. This also suggests that the door remains open with regard to future short-term rate increases. Mr. Powell noted that it is certainly possible that policy is now at a sufficiently restrictive level to bring inflation back down to 2% over time, but only time will tell.

The Fed has been lifting rates to try to bring inflation to heel. Goosed by over-ample fiscal stimulus and easy monetary policy, price increases roared to a 40-year high not long ago, and have been slow to settle. Prices for goods and energy have retreated the most, helping to pull PCE-measured inflation down from a 7% peak in June 2022 to "just" 4.2% by this March. But service (mostly labor) costs remain stubbornly high, so the "core" PCE the Fed most closely tracks has only drifted lower, easing from a 5.2% peak annual rate last September to 4.6% in March. This is a small step in the right direction, but core PCE remains more and two-and-a-half times the Fed's target, and it may take another increase in short-term rates yet to nudge it toward that goal more quickly.

While the labor market remains tighter than the Fed wants to see, there have been some signs of loosening at the margins. We'll learn what happened with hiring for April on Friday May 5; while still strong, the March report shows a downshift in new jobs filled compared with much of the last two years. As well, initial claims for unemployment benefits tell much the same story; still low and fairly steady, but rather above the lowest levels of the post-pandemic expansion. In addition, the March update for the Job Openings and Labor Turnover Survey (JOLTS) also continued to step away from its tightest levels, with the still-high 9.59 million open positions in March the smallest number in about two years. Despite the slight loosening in labor conditions, wage increases remain above levels the Fed feels are consistent with inflation retreating back to the 2% core PCE mark for which they are aiming, and the labor market will likely need to loosen up more to achieve that goal.

The latest increase in the federal funds rate could possibly be the last in this cycle. The current interest rate for federal funds may now be at a moderately restrictive level, and this may or may not be sufficient to drive inflation back down as quickly or meaningfully as the central bank wants. It is not out of the realm of possibility that the Fed pauses for a time and then lifts rates again; at least one other central bank has already done so. After the close of the May meeting and press conference, futures markets placed only about a 8% chance of another increase come June, up slightly from just before the meeting took place.

The Fed's March projections for the "terminal rate" for the federal funds remained at median of about 5.1% for 2023. This would indicate that the range for this rate would be one of 5% to 5.25%, so by the Fed's most recent reckoning, we have arrived at our destination, as the phrase goes. We won't know if this is a temporary stop or not until June at the earliest, or at least until the data suggests a more meaningful change in the downward trajectory for prices.

Changes in monetary policy and associated "tightening of financial conditions" affect the real economy with a unknown time lag. In just a year's time, the Fed has moved its key policy rate rapidly from near-zero to the highest policy rate in more than 16 years, so there may still be some yet-unrealized economic drag in the pipeline from previous increases still to be seen. How much -- and how resilient is the economy and how resistant are price pressures despite these headwinds -- is yet unclear.

In addition to raising rates, the Fed is continuing the process of "significantly" reducing its balance sheet and is now retiring $35 billion of MBS and $60 billion of Treasury debt from its investment portfolio each month. Higher market-engineered mortgage rates over the last year crushed refinancing, slowed mortgage market activity significantly, and softened housing markets appreciably, and there are starting to be signs that home values are declining in some areas.

Achieving desired levels of portfolio runoff of mortgage holdings may eventually see the Fed need to 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 and is highly likely to run below desired levels, and has been since the runoff program began more than nine months ago.

The general process of balance-sheet reduction is accomplished by no longer using the proceeds of inbound interest and principal payments from existing holdings to buy more bonds. As such, reductions in holdings are happening as borrowers whose mortgages make up those MBS pay down their loan balances, which any homeowner knows is a slow process.

As of April 26, the Fed held $2.576 trillion in mortgage paper, down from a recent peak of $2.740 trillion in April, so the reduction isn't happening at the pace the Fed has dictated -- $367.5 billion should have been trimmed by now, but the decline has only been about $164.4 billion so far, less than half of what the Fed was hoping for.

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.

The Fed's next scheduled meeting comes June 13-14. There will be an updated Summary of Economic Projections released at that meeting, which should provide a clearer picture of the Fed's thinking about the direction for the overall economy, inflation, the labor market and the potential for future policy moves this year and beyond.

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 May 3, 2023 was the tenth 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 is perhaps 2.5 percent or so, a level well below what has long been considered to be a "normal" level. The Fed has raised the federal funds rate well above this normal level in order to temper inflation pressures that rose to more than 40-year highs in 2022. Once the Fed cycle of increases is complete, short-term rate may be slow to retreat to the Fed's "long-run" 2.5% rate. In March 2023, the central bank's own forecast doesn't expect for it to return there until 2026 at the very earliest.

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 a 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. In August 2019 the Fed 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, which at the time comprised of about $2.08 trillion in Treasuries and about $1.52 trillion in mortgage-related debt. At the time, the Fed began changing its mix of holdings, using inbound proceeds from maturing investments to purchase Treasury securities of various maturities to roughly mimic the overall balance of holdings by investors.

At the same time, 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 were repaid was expected to take many years.

HSH.com Federal Reserve Policy Tracking Graph

Then came COVID-19.

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. Through October 2021, the running rate of outright purchases of MBS was $40 billion per month, and inbound proceeds from principal repayments on holdings and refinancings were also being reinvested in additional purchases. MBS bond buys were trimmed to $30 billion per month starting in December 2021 and then to $20 billion per month in January and it was expected that a similar pace of reduction going forward would occur.

Since the Fed restarted their MBS purchasing program again in March 2020, it had by mid-April 2022 added more than $1.37 trillion of them to its balance sheet, and total holdings of MBS topped out at about $2.740 trillion dollars. The Fed's MBS holdings had doubled since March 2020.

The Fed has since concluded its bond-buying program. The start of a "runoff" process to reduce holdings was announced at the close of the May 2022 meeting and began in June 2022 Reductions of $17.5 billion in MBS in the first three months of the program increased to $35 billion per month in September 2022, and reductions in holdings remain at this pace today.

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. Persistent inflation has reinforced this cycle, and will until short-term rates are raised high enough to slow the economy and cool price pressures.

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 also 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 six increases in the federal funds rate so far may be joined by several others yet 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 at near zero until March 2022, but fixed mortgage rates rose by better than three quarters of a percentage point in the months the preceded the March 17 increase. Rates increased amid growing economic strength and a increasing concern about broadening and deepening inflation.

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.

The prime rate usually increases or decreases within a day or two of a change in the federal funds rate.

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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