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How The Federal Reserve Affects Mortgage Rates

One of the core missions of the Federal Reserve is to maintain a stable rate of inflation. Their primary tool for doing this is something called the federal funds rate. The federal funds rate (or Fed funds rate) is the rate at which banks borrow money from each other overnight.

By controlling the amount of money banks borrow from each other, it helps the Fed effectively control the money supply. If short-term interest rates are low, money is cheaper to borrow, which has the effect of increasing the overall money supply in the market and pushing prices up. On the other hand, if interest rates are higher, less money is available, and prices go down.

The Federal Reserve has been keeping short-term interest rates at or near 0% most recently in response to COVID-19. This has the effect of keeping mortgage interest rates lower.

Typically, when the federal funds rate is low, that would have the effect of pushing inflation up over time. However, so far that hasn’t been the case. Inflation has fallen short of the Fed’s 2% annual goal for the last several years now, but was spiking at the end of 2021 at 6.2% in October.

The Fed would actually like to see prices go up a little bit each year because it stimulates the economy by pushing people to buy now rather than wait, especially if they think prices might rise in the future.

How The Overall Economy Affects Mortgage Rates

Both the Federal Reserve and the overall markets are reacting to the ups and downs of the economy as a whole. 

Generally, if people believe we’re in prosperous times, they’ll move their money into stocks and away from bonds for the chance at a higher return. Mortgage rates end up moving up. If investors believe we’re looking at a downturn in the future, money gets moved back into bonds and mortgage rates go down.

Inflation also plays a role. When inflation is higher, people are more incentivized to invest in stocks. The reasoning is that the guaranteed rate of return on bonds gets eaten into as inflation rises.

If a bond pays you back 5% and the money supply is increasing at a rate of 3% per year, you’re only getting an effective 2% return. It’s worth noting that, if you already have a fixed-rate mortgage, your payment won’t change based on inflation.

Finally, unemployment plays a part. If more people are unemployed than the Fed would like to see, they tend to lower interest rates to stimulate borrowing, which in turn may be used to help grow a workforce