How the Federal Reserve Affects Mortgage Rates

While the Federal Reserve doesn’t set mortgage rates, it certainly affects them through its conduct of monetary policy. Because of the housing sector’s economic importance, mortgage rates are an important channel through which changes in the Fed’s monetary policy affect consumer balance sheets and spending. This is most easily seen when the Fed adjusts the federal funds rate, which bankers and lenders use to set mortgage rates. If the Fed raises the federal funds rate, it’s more expensive to lend, and lenders will charge higher mortgage rates.

Tools of Monetary Policy

The Federal Reserve works to meet its mandate to promote price stability and maximum employment through monetary policy. The Fed’s primary monetary policy tool is the federal funds rate. Other monetary policy tools include large-scale asset purchases and open market operations.

Federal Funds Rate

The federal funds rate is the rate that United States financial institutions (such as banks, credit unions, and others in the Federal Reserve System) charge each other for overnight loans of reserves deposited at the Fed. While the rate for each loan is negotiated between the lending and borrowing institutions, the Fed uses open market operations to keep the rate within its target range.

The federal funds rate sets the floor for all other interest rates on government and private debt. Changes in the federal funds rate influence other interest rates through credit spreads and duration risk premia, but the effects aren’t always predictable or orderly.

Changes in the federal funds rate and Federal Open Market Committee (FOMC) statements about its likely direction in the future signal the Fed’s assessment of the economy’s prospects to financial markets participants.

Open Market Operations

The Fed uses open market operations to keep the Federal Reserve rate within its target range. It does this by entering repurchase and reverse repurchase agreements with banks and other market participants. Repos and reverse repos, as they are often called, are effectively overnight loans and borrowings, respectively, by the Fed, collateralized by Treasury securities holdings.

For example, in raising its federal funds rate target to a range of 0.75% to 1% on May 4, 2022, the FOMC authorized the Federal Reserve Bank of New York, which traditionally enacts Fed policy, to initiate open market operations to maintain the federal funds rate within that range. It approved overnight repurchase agreement operations (Fed lending, in effect) with a minimum bid rate of 1% and an aggregate limit of $500 billion to keep the federal funds rate from exceeding 1%. At the same time, the FOMC authorized overnight reverse repurchase agreements (Fed borrowing, in effect) at a minimum rate of 0.8% to keep the federal funds rate from dropping below 0.75%. The only limit on the reverse repos was a maximum of $160 billion per day per counterparty.

Large-Scale Asset Purchases

The Fed’s balance sheet stood at less than $1 trillion in September 2008, rising to $4.49 trillion by November 2014, as the Fed completed the asset purchases prompted by the global financial crisis. The Fed’s balance sheet was still above $4 trillion when COVID-19 struck in 2020, and it more than doubled as a result of an open-ended asset purchase program adopted at the time to support the economy amid the pandemic. It’s balance sheet has since fallen to approximately $7 trillion over the past year.

Large-scale asset purchases assumed a crucial role in the Fed’s monetary policy once the federal funds rate dropped to zero, leaving the central bank no further room to support growth by cutting it. With the benchmark rate as low as it could go, asset purchases assumed the burden of signaling the Fed’s policy intentions to financial market participants.

While the large absolute numbers involved sparked controversy, it’s important to note that in conducting monetary policy, the Fed has no funding constraints. As the issuer of U.S. currency, it can increase its balance sheet to whatever size it deems necessary to support its policy mandate. This unlimited funding capacity is, in part, what compels the markets to act on the Fed’s policy signals. And while it’s impossible to know exactly what might have transpired in the absence of large-scale asset purchases, economic models offer a partial answer. By one estimate, just one of the three rounds of quantitative easing, carried out from late 2012 to 2014, raised the inflation rate by one percentage point while lowering the unemployment rate by four percentage points from where it would have stood without the asset purchases by the end of 2015.

Other Monetary Policy Tools

In addition to the policy tools above, the Fed can affect interest rates by changing bank reserve requirements, changing the terms on which it lends to banks through its discount window, and changing the rate of interest that it pays on the bank reserves it has on deposit.

Ripple Effect

When the Fed makes it more expensive for banks to borrow by targeting a higher federal funds rate, the banks, in turn, pass on the higher costs to their customers. Interest rates on consumer borrowing, including mortgage rates, tend to go up. And as short-term interest rates increase, long-term interest rates typically also rise. As this happens, and as the interest rate on the 10-year Treasury bond moves up, mortgage rates also tend to rise. 

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 interest rates, providing another lever by which monetary policy affects mortgage rates and lending.

Examples of Federal Reserve Affecting Mortgage Rates

In response to the global financial crisis of 2008, the Fed embarked on a series of large-scale asset purchase programs, known as quantitative easing, buying mortgage-backed securities and Treasury debt. Purchases tied to the global financial crisis ended in 2014. The Fed initiated a new large-scale asset purchase program in 2020 as the pandemic struck.

In both instances, Fed purchases of securities increased their price, lowering yields, at moments of credit market crisis. The Fed encouraged banks to fund mortgages at lower interest rates by buying mortgage-backed securities and keeping their yields low.

Conversely, the tightening of monetary policy by the Fed in early 2022 translated into significantly higher mortgage rates.

The average 30-year fixed mortgage rate as reported by the Mortgage Bankers Association was at 3.3% in the first full week of 2022, as minutes from the December 2021 meeting of the FOMC—the Fed’s panel for setting monetary policy—disclosed that “many participants judged that the appropriate pace of balance sheet runoff would likely be faster than it was during the previous normalization episode” and that some policymakers favored a shift in the balance of Fed holding away from mortgage-backed securities and toward Treasuries.

By late January 2022, as the FOMC signaled that it would stop adding to the Fed’s balance sheet by March, the 30-year fixed mortgage rate had risen to 3.72%. It rose to 4.27% in mid-March as the FOMC raised its Fed funds rate target by a quarter of a percentage point and prepared the market for a series of larger rate hikes and the start of a drawdown for Fed assets in the months ahead.

By early May 2022, the 30-year fixed mortgage rate had risen to 5.36% as the Fed announced a 50 basis point rate (0.5%) hike and said it would start reducing its balance sheet from June 1 by $30 billion monthly in Treasury securities and $17.5 billion monthly in holdings of housing agency debt and agency mortgage-backed securities.

Note that the benchmark 30-year mortgage rate rose from 3.5% to 5.10% during the first four months of 2022 even though the Fed hadn’t yet even started reducing its $8.94 trillion balance sheet while increasing its federal funds rate target by just 0.75% over that time, still far below the rate of inflation. That’s because monetary policy does a lot of work via its signaling function. If the Fed credibly promises to increase interest rates while reducing its mortgage securities holdings, the market will price in those expectations long before the Fed follows through.

The Bottom Line

The Fed aims to maintain economic stability, and the tools that it uses affect bank lending rates. When the Fed wants to boost the economy, it typically becomes less expensive to take out a mortgage. Conversely, when the Fed needs to slow inflation, it acts to drain liquidity from the financial system, which typically results in a higher interest rate on mortgages.