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How The Federal Reserve Affects Mortgage Rates

Author: Michael Taylor

The rate on a 30-year fixed mortgage has been at historic lows in recent years—hovering around 3.5 to 4 percent. This has come about as the Federal Reserve has taken several unusual steps to revive the U.S. economy following the 2007 financial crisis and subsequent Great Recession. While the Fed does not have the ability to directly set mortgage rates, it does create the monetary policies that indirectly affect these rates. (Related How Much Influence Does The Fed Have?)

For example, in response to the financial crisis, the Federal Reserve took the unusual step of embarking on a quantitative easing program in which it bought up mortgage-backed securities and government debt in the form of Treasury bonds. The program, which began in November 2008 and ended in 2014, increased the money supply in the nation's financial systems. This encouraged banks to lend money more easily. It also drove up the price and drove down the supply of the types of securities that the Fed bought. All these actions had the effect of keeping lending rates, including mortgage rates, low. (Related Quantitative Easing: Does It Work?)

Tools of Monetary Policy

The Federal Reserve aims to influence the economy, inflation, and employment levels through its monetary policy. One of the tools it uses to conduct monetary policy is setting a target for the federal funds rate. This is the short-term interest rate at which U.S financial institutions (such as banks, credit unions, and others in the Federal Reserve system) lend money to each other overnight in order to meet mandated reserve levels. Each borrowing and lending bank negotiates the interest rate individually. Together, the average of all these rates make up the fed funds rate.

As with mortgage rates, the Federal Reserve does not directly set the federal funds rate. Instead, it sets a target for the federal funds rate and engages in actions to influence the rate to towards the target. The federal fund rate affects all other rates including short- and long-term interest rates and forex and also has a host of downstream effects. In recent years, the Fed has maintained its target fed funds rate at the lowest it can go—from 0 percent to .25 percent.

A major way the Fed can influence the fed funds rate is by wielding another one of its monetary policy tools—open market operations. This is when the Fed buys and sells government securities such as bonds. When the central bank wants to tighten monetary policy and targets a higher fed funds rate, it absorbs money from the system by selling off government bonds. And when it wants an easier monetary policy and targets a lower fed funds rate, the Fed engages in the opposite course of action of buying government securities so as to introduce more money into the system. Where does the money to buy all these government bonds come from? As the central bank, the Fed can simply create the money.

In addition to targeting a fed funds rate and using open market operations, the Fed also has other tools to influence monetary policy. These include changing bank reserve requirements by making them higher or lower, changing the terms on which it lends to banks through its discount window, and changing the rate of interest it pays on the bank reserves it has on deposit.

Ripple Effect

When the Federal Reserve makes it more expensive for banks to borrow by targeting a higher federal funds rate, the bank in turn pass on the higher costs to its customers. Interest rates on consumer borrowing, including mortgage rates, tend to go up. And as short-term interest rates go up, long-term interest rates typically also rise. As this happens, and the interest rate on the 10-year Treasury bond which influences the rate on the conventional 30-year mortgage moves up, mortgage rates also tend to rise. (Related The Tangled Web of Interest Rates, Mortgage Rates, And The Economy)

Mortgage lenders set interest rates based on their expectations for future inflation and interest rates. The supply of and demand for mortgage-backed securities also influences the rates. Thus, the Federal Reserve's actions have a ripple effect in terms of impacting mortgage rates.

The Bottom Line

The Federal Reserve's actions as it aims to maintain economic stability impact bank lending rates. When the Fed wants to boost the economy, it typically becomes less expensive to take out a mortgage. And when the Fed wants to clamp down on the economy, it acts to drain money from the system, which means borrowers will likely pay a higher interest rate on mortgages.

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