How the Federal Reserve Affects Mortgage Rates

BY THE PERK LENDING TEAM | May 22, 2023 | 4-minute read

The mortgage rates available at any given time are the result of numerous economic and regulatory forces. One of those forces is the Federal Reserve.

The Federal Reserve, or “the Fed” for short, is the central banking system of the United States. Its purpose is to promote the effective operation of the U.S. economy. Specifically, its goals are maximum sustainable employment, stable prices, and moderate long-term interest rates.

How does the Fed raise rates?

The Fed doesn’t directly set any long-term interest rate. Instead, it sets the interest rate range on overnight loans between financial institutions using excess reserves deposited with the Fed. This rate, called the federal funds rate, is the shortest-term interest rate in the country and sets the lower bound for interest rates on longer-term loans.

Why would the Fed raise the Federal Funds Rate?

The Fed wants to keep inflation at 2% each year. High inflation negatively impacts consumers because they are paying higher prices for goods and services. Raising the federal funds rate is a tool the Fed uses to try to stop rising inflation.

When high inflation is present, their goal is to make borrowing money more expensive. Raising the floor on short-term interest rates can push up longer-term rates. Higher borrowing costs reduce spending and investment in the economy, bringing prices down. Once prices come down, the Fed can reverse course and reduce rates to make borrowing cheaper, increasing demand and spending.

Caveats

Changes to the federal funds rate have the strongest effect on shorter-term debt, like 1-year treasuries. Long-term interest rates are determined by more than just the current overnight borrowing rate available to financial institutions. The type of loan, market sentiment, and creditworthiness of the borrower, among other factors, all play into the interest rates charged at any given time.

What the Fed says is usually just as impactful as what it does. Interest rate rhetoric from a Fed official can cause volatility in longer-term interest rates before any actual adjustments are made. Mortgage rates tend to react immediately to changes in rate expectations.

Quantitative Easing

Quantitative easing is a strategy used by central banks to help bolster an economy when growth is stagnant and interest rates are already near zero. It involves large-scale purchasing of financial assets to increase the money supply, lower long-term interest rates, and boost economic growth.

After the 2008 Financial Crisis, the Fed became one of the largest buyers of government bonds and mortgage-backed securities (MBS). This helped push long-term rates down, making home financing more affordable and restoring faith and demand in both the housing and securities markets.

The Fed continued its asset purchasing program through the Covid-19 pandemic to further support the economy. However, in 2022, the Fed stopped buying and began selling its MBS holdings in the open market. Large-scale selling in the MBS market caused mortgage rates to rise.

Conclusion

There is a lag on Fed rate hikes slowing down inflation, but consumers and borrowers tend to feel the effects immediately. Because of the lag, there is no sure way to know when interest rates will change. But the Fed will do what it needs to in order to prevent the economy from overheating or stagnating.

Regardless of the interest rate environment, there is no bad time to buy a home. With the right plan and mortgage product, you can take advantage of any rate environment and start building wealth with real estate. Ready to begin? Fill out an application to see what mortgage options are available to you.

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