How the Fed influences interest rates

The Federal Reserve (or “the Fed”) elected not to raise the Federal Funds Rate during its October 2015 meeting. The Fed announced that it wants to see additional improvement in the labor markets and a slight increase in inflation before it will raise interest rates. In response, mortgage rates were reported to start rising. The Fed plays an important, but indirect, role in setting mortgage rates and understanding this role can help prospective home buyers get the best rates on their mortgage.

The Fed does not directly control mortgage rates, but its decisions have a large impact on whether mortgage rates are headed up or down. The Fed is largely involved with controlling inflation and does so by setting short-term interest rates. These interest rates greatly determine long-term interest rates, like the yield of the U.S. Treasury 10-year bond. The 10-year bond has the same lifespan as most mortgage loans, so many mortgage rates are priced at a premium to these Treasury bills. Because the interest on 30-year fixed-rate mortgages is highly correlated with the yield of the U.S. Treasury 10-year bond, the short-term interest rates that the Fed sets have a large impact on mortgage rates.

The Fed can affect mortgage rates in other ways as well. Banks are required to hold a certain amount of money in relation to their reserves, which is known as the reserve requirement. Usually, banks are required to hold about 10 percent of their deposits on reserve. Often, the banks holdings fall below the requirement during their day-to-day operations, so they often borrow from other banks on a short-term basis. The interest rate on these transactions is known as the federal funds rate, which is set by the Fed. Often, banks will raise or lower their rates in response to the discount rate, so when the Fed increases the discount rate, then banks will often pass the higher charge on to consumers in the form of increased mortgage rates.

The Fed can also impact mortgage rates by buying and selling debt instruments, short-term Treasuries, and securities backed by mortgages. When the Fed sells off securities, it removes money from the reserve accounts of banks so that they end up with less in reserve. As a result, banks are more likely to borrow to make up for the shortfall, all of which tend to drive up the federal funds rate and, in turn, mortgage rates. Conversely, when the Fed buys securities it credits money to the reserve accounts of banks and they have less need to borrow. This drives interest rates down, which usually drags mortgage rates down with it.

So, while the Fed does not directly control mortgage interest rates, it does greatly influence them. To forecast changes in mortgage interest rates, it is advisable to examine the shape of the yield curve, which represents the yields on U.S. Treasury bonds. When the curve is flat or downward, the market expects the Fed to keep short-term interest rates steady or low, in turn keeping mortgage rates lower. When curve slopes upward, it may indicate rising interest rates.

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