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How the Federal Reserve Affects Mortgage Rates

The Federal Reserve is one of many influences on mortgage rates, along with inflation, economic growth and other elements.
March 17, 2020
Mortgage Rates, Mortgages
How the Federal Reserve Affects Mortgage Rates
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The Federal Reserve doesn’t set mortgage rates, but it does affect mortgage rates indirectly.

Mortgage rates are determined by many elements, including the inflation rate, the pace of job creation, and whether the economy is growing or shrinking. The Federal Reserve’s monetary policy is a factor, too, and is set by the Federal Open Market Committee.

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What the Federal Reserve does

The Federal Reserve is the nation’s central bank. It guides the economy with the twin goals of encouraging job growth while keeping inflation under control.

The FOMC pursues those goals through monetary policy: managing the supply of money and the cost of credit. Its main monetary policy tool is the federal funds rate, which is the interest rate that banks charge one another for short-term loans. Although there’s no such thing as “federal mortgage rates,” the federal funds rate influences interest rates for longer-term loans, including mortgages.

The FOMC meets eight times a year, roughly every six weeks, to tweak monetary policy. Most meetings result in no change to the federal funds rate. At the conclusion of each meeting, the committee releases a statement explaining its reasoning. Three weeks later, the meeting’s minutes are released, serving Fed nerds even more details.

Do mortgage rates follow Fed rates?

The Fed and the mortgage market move like dance partners: Sometimes the Fed leads, sometimes the mortgage market leads, and sometimes they dance on their own.

The federal funds rate and mortgage rates usually move in the same direction. But it’s hard to say whether mortgage rates follow the Fed’s actions or the other way around.

The federal funds rate influences interest rates for longer-term loans, including mortgages.

The FOMC prefers to give investors a heads-up whenever it plans to raise or cut short-term interest rates. Members of the committee advertise their intentions by sprinkling hints into their public speeches. By the time the committee meets, there’s usually a consensus among investors as to whether the Fed will cut rates, raise them or keep them unchanged.

As that consensus solidifies before an FOMC meeting, mortgage rates usually drift in the direction that the Fed is expected to move. Often, by the time of the meeting, mortgage rates already reflect the expected rate change.

At the same time, mortgage rates move up and down daily in reaction to the ebbs and flows of the U.S. and global economies, which are the same developments that the Fed responds to. Occasionally, the Fed and mortgage rates move in opposite directions.

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What is the current federal funds rate?

The FOMC cut the federal funds rate a full percentage point March 15, 2020, in an emergency response to the COVID-19 pandemic. The target federal funds rate was reduced to a range of 0% to 0.25%.

“The coronavirus outbreak has harmed communities and disrupted economic activity in many countries, including the United States. Global financial conditions have also been significantly affected,” the rate-setting committee explained.

It added, “The effects of the coronavirus will weigh on economic activity in the near term and pose risks to the economic outlook.”

The central bank said it plans to keep the federal funds rate near zero “until it is confident that the economy has weathered recent events and is on track to achieve its maximum employment and price stability goals.”

A reduction in the federal funds rate wasn’t the Fed’s only action. It announced a round of quantitative easing, a form of economic stimulus that the central bank used for six years after the 2008 economic crisis.

In the 2020 version of quantitative easing, the Fed will buy at least $500 billion of Treasurys and at least $200 billion of mortgage-backed securities. The goal is to add cash to the mortgage banking system to reassure lenders that it’s safe to lend because the Fed is willing to buy the resulting mortgage-backed securities.

Quantitative easing from 2008 to 2014 was successful in inducing banks to lend to businesses and consumers. Another goal of quantitative easing — to raise the inflation rate to 2% — had limited success. Higher inflation gives businesses and consumers a reason to spend instead of save. Spending stimulates the economy.

After its April 28-29, 2020, meeting, the Fed emphasized that it “is committed to using its full range of tools to support the U.S. economy in this challenging time” and said the health crisis will weigh on the economy “over the medium term.” In a news conference, chairman Jerome Powell defined “the medium term” as about a year, depending on the progress of efforts to get COVID-19 under control.

Federal funds rate and HELOCs

Although the Fed doesn’t determine mortgage rates, it does have a direct influence on the rates charged on home equity lines of credit, which typically have adjustable rates.

Interest rates on HELOCs are linked to the Wall Street Journal prime rate, which is the base rate on corporate loans by the largest banks. The prime rate, in turn, moves with the federal funds rate.

When the FOMC cuts the federal funds rate, interest rates on HELOCs go down, too. The March 15 reduction of one percentage point saves $100 a year — or $8.33 a month — on the interest-only payment of a HELOC with a $10,000 balance. It reduces the prime rate to 3.25% from 4.25%.

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