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If the Fed raises short term rates - what does it mean for mortgage rates?    

 

by Keith Luedeman, Managing Director   

News 

7/27/2016 - Fed Holds, Decision Not Unanimous
 
As expected, the FOMC voted once again to leave its target interest rate range unchanged between 0.25% and 0.50%. The Committee, once again, elected not to address the “balance of risks” issue. Had they done so, it would have been a strong signal that the Committee was strongly considering a September hike. Economists and analysts were curious to see how the Committee would characterize two major topics: (1) recent fluctuations in the U.S. labor market and (2) the impact that Brexit on the U.S. economy. The Committee nodded to the rebound in the June jobs report, stating “the labor market strengthened” and that “Job gains were strong in June following weak growth in May.” While Brexit wasn’t specifically addressed, the Committee added a statement noting, “Near-term risks to the economic outlook have diminished,” implying members currently see less acute risks to the U.S. economy from a U.K. exit. As to other aspects of the economy, the Committee’s characterization was similar to recent statements:
 

  • Economic Activity: “expanding at a moderate rate”
  • Personal Consumption: “has been growing strongly”
  • Business Investment: “has been soft”
  • Inflation: “continues to run below the Committee’s 2 percent longer-run target” but is expected to “rise to 2 percent over the medium term”
  • Inflation Expectations: Market-based - “remain low”, Survey-based “little changed”

 
Overall, the Statement appears to be neutral, though the improvement in the labor assessment and the apparent calm surrounding the impact of Brexit tilt slightly hawkish.

Kansas City Fed Bank President Esther George dissented to the decision, preferring to hike rates to 0.50% to 0.75%. George had voted to leave the rate unchanged in June, making the previous decision unanimous.
 
Text of the full release here.
  
6/15/2016 -
Fed Holds, Lowers Forward Guidance for Rate Hikes
 
The FOMC voted to leave their target rate range unchanged at 0.25% to 0.50%, giving a mixed assessment of economic conditions and a much lower forecast for their target rate path. The Official Statement noted that job growth “has slowed” even though economic activity has “picked up”. The Statement also notes the “strengthening” in household spending, which had been quite disappointing in 1Q but appears to be turning the corner in 2Q. The Statement also notes the recent strengthening in the housing sales data and the smaller drag on growth from external trade. The FOMC continues to see business investment as soft.
 
Omitted from this statement was the sentence saying, “A range of recent indicators, including strong job gains, points to additional strengthening of the labor market.” However, the Statement later notes that labor market is expected to strengthen.

As it relates to inflation, the Committee continues to believe that inflation will rise to the 2 percent target over the medium-term. They did, however, note that inflation expectations have come down.
 
Kansas City Fed Bank President Esther George, who dissented to the March and April decisions preferring to raise rates each time, did not dissent.
 
In the Summary of Economic Projections, FOMC officials made notable changes to their forecasts for the overnight target rate range. The average forecast for year-end 2016 was 1.02% in the March SEP, but was lowered to 0.83% in the current SEP. The average projection for year-end 2017 was reduced from 2.04% to 1.63%. The average projection for year-end 2018 was reduced from 2.95% to 2.46%. And the average rate expected in the longer-run was reduced from 3.31% to 3.14%. also in the Committee’s projections, the economy is expected to grow 2.0% in 2016, down from 2.2% in the March survey. Growth in 2017 is now expected to be 2.0%, down from 2.1% in the March SEP.
 
Text of the full release here.
  
4/27/2016 -
Fed Slightly Dovish, Less Concerned about Global Risks
 
The FOMC voted once again to leave its target interest rate range unchanged between 0.25% and 0.50%. Overall, the Statement appears to be a bit dovish relative to expectations going into the meeting. The Committee did not address the “balance of risks” issue, once again passing on making an assessment. This implies that there remains a material difference of opinion within the Committee, one that may not be settled by June. Had the Committee stated that the balance of risks were “balanced” or “nearly balanced,” this would have been seen as a harbinger of the Committee being open to a June hike. By not doing so, this Statement has reduced the likelihood of a June hike, although it is not off the table entirely.
 
The FOMC’s assessment of the economy was mixed. Characterizations of economic activity and household spending were lowered while household real income and consumer sentiment were noted as improving. The Statement also omitted the phrase saying that “global economic and financial developments continue to pose risks” and replaced it saying that they are closely monitoring global conditions.
 
Overall, the Statement appears to be dovish given the omission of a characterization of the balance of risks. The markets, however, have responded as though it were more hawkish with the 2-year Treasury yield rising 3 bps to 0.86% and the Dollar rallying immediately after the release.
 
Text of the full release here.
 
3/16/2016 -
Fed Sees Economy As Growing But Weakness Exists
 
The FOMC voted to leave its overnight target rate at 0.25%-0.50% citing global economic and financial market turmoil. The overall assessment of the economy was mixed, noting that the economy has been expanding at a moderate pace but also noting weakness in business investment and external trade. The Official Statement does reference the recent increase in inflation but notes that 1) inflation remains below the Fed’s 2% target, 2) market-based measures of inflation expectations remain low, and 3) consumer inflation expectations remain low. In fact, despite the recent increase in inflation, the Fed lowered its core PCE projection for 2017 from 1.9% to 1.8%. While they chose to wait at this meeting, they certainly did not close the door to a rate hike in April or June. Dissenting to the vote was Kansas City Fed Bank President Esther George who preferred to raise rates.

However, the big news in the Fed’s release was the change in the Summary of Economic Projections. FOMC participants dropped their median Fed Funds rate projection for year-end 2016 from 1.375% (implying four rate hikes this year) to 0.875% (implying just two rate hikes this year). The Fed’s forecast for the path of its target rate is now much more closely aligned with market-based expectations. As for the target rate at YE 2017, the FOMC lowered its median projection from 2.375% to 1.875%. The longer-run target rate, the rate at which the Fed believes the target rate will eventually be when policy is fully normalized, was once again lowered. The longer-run target rate is now projected to be just 3.25%.

The markets have responded swiftly to the lower rate outlook from the Fed. The 2-year Treasury yield dropped from 0.98% to 0.89% immediately after the release. The 10-year Treasury yield dropped from 1.99% to 1.93%. The DJIA rose 84 points, oil rose 1%, and the Dollar dropped 0.5%.
 
Text of the full release here.
 
1/27/2016 -
Fed Focus on Inflation, Not Confident
 
The FOMC voted unanimously to leave the Fed Funds Target Range unchanged at 0.25% to 0.50%. The overall Statement was dovish, citing less certainty about inflation moving back toward the stated target of 2%. Most notably, missing from the Statement was the key phrase that the “Committee sees risks to the outlook...as balanced.” Also missing was the equally important phrase that the Committee is “reasonably confident that inflation will rise, over the medium term, to its 2 percent objective.” The Statement notes that “market-based measures of inflation compensation declined further” and that “survey-based measures of longer-term inflation expectations” remain low. The Statement credits lower inflation expectations, particularly in the near-term, to the “further declines in energy prices.” While the Statement still reflects expectations for inflation to move toward 2%, the Committee is certainly less confident of this.
 
The FOMC is now completely focused on inflation as the trigger for future policy decisions. With oil prices remaining lower-than-expected, the outlook for inflation has fallen. It will be very difficult to justify rate hikes this year so long as this remains the case. In association with the Official Statement, the Fed also released a statement reaffirming that “its inflation objective is symmetric.” This means that the Committee is just as committed to fighting inflation running below 2% as it is to fighting inflation running above 2%.
 
Regarding the economic outlook, the Statement had mixed messages. It noted that labor market conditions have improved further along with the housing market. However, the Statement also noted that growth “slowed late last year” and tempered its assessment of household spending and business investment, noting that they have been growing at “moderate rates” rather than “solid rates.” It also noted that “inventory investment slowed.”
 
Immediately following the release of the Statement, Treasury yields moved slightly lower with the 2-year yield down from 0.88% to 0.84% and the 10-year yield down from 2.05% to 2.02%. Fed Funds Futures contracts now price in a 27% chance of a rate hike in March and a 51% chance of a hike in June.
 
Text of the full release here.
 
12/16/2015 -
Fed Hikes, Watching Inflation
 
For the first time in 58 FOMC meetings, exactly 7 years to the day after the last Fed rate drop, the Fed voted unanimously to raise the overnight target rate range from 25% to 0.50%. Going forward, the Official Statement notes that “the Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate.”
 
Along with this rise in the Fed Funds rate by 1/4, there is also a rise in the discount rate, and the more important Prime Rate that banks use to lend to consumers of prime credit.
 
At issue is the FOMC’s confidence that inflation will rise back to its 2% target. Twice the Statement reflects less confidence in inflation’s path. First, the Statement notes that “some survey-based measures of longer-term inflation expectations have edged down.” Later, the Statement notes that the Committee is “reasonably confident that inflation will rise, over the medium term, to its 2 percent objective.” Every word is chosen carefully by the FOMC and hedging their confidence by saying they are “reasonably” confident is relevant. For now, the Committee expects the progress made in the labor market will lead to wage inflation which will eventually lead to broader price inflation. However, all of the current measures of inflation remain less compelling. Wage growth has not turned sustainably higher, commodity prices are down 15.5%  for the past year, and oil prices are down 37%. Focus has now turned from the labor statistics to inflation.
 
Text of the full release here.

Click here to review fed rate changes since 1990. 

Click here to review prime rate changes.

Click here for a recap of Fed Meetings from 2008 - 2016 when the rates were very stable..

 

The Federal Reserve met today to consider policy on short-term interest rates.  The Federal Reserve had cut two key short-term interest rates 11 times over the past few years to fight the recession - for the last time in December of 2008.  7 years later to the day, they raised rates by a quarter point.

 

Early they decided to raise the Discount rate during their February 2010 meeting, after keeping both rates stable since December of 2008.  

The two short-term interest rates the Fed controls are the federal funds rate and the more symbolic discount rate.

The fed funds rate -- short for federal funds rate -- is the interest rate at which banks lend to each other overnight. The Fed sets this rate by buying or selling government securities until the target level is achieved. As such, it is a market interest rate.

The discount rate is the interest rate charged by a Federal Reserve Bank on short-term loans to depository institutions. The discount rate is important for two reasons: (1) it affects the cost of reserves borrowed from the Federal Reserve and (2) changes in the rate can be interpreted as an indicator of monetary policy.

 

These two rates do affect the economy and it's performance.  However, the rate cuts do take 4-6 months to work their way through the nation's economy.

Another rate influenced by, but not directly controlled by the Fed is Prime rate. This is the rate charged by commercial lenders on short-term loans to their lowest-risk, most creditworthy customers, such as large corporations. Often serves as a basis for rates on other loans.

 

Mortgages rates have been on the decline for the last few years - reaching their lowest levels in years.

 

The Fed's rate decisions affect mortgage rates setting the levels of 1 year adjustable rate mortgages and indirectly through the Fed's influence on longer-term rates that bond markets set.

 

We've had many people call us and ask - will mortgage rates go up when the Fed raises rates?

 

The answer - it depends.    

 

Basically, short term rates are raised on the basis to slow economic growth and thus inflation.  If the rate cuts are successfully the economy begins to grow less rapidly, which decreases the demand for capital. As the demand for capital lessens, over time, the law of supply and demand ultimately pushes interest rates lower. 

Mortgage rates are often much longer-term financial instruments - not short term rates -  since mortgages can be over a term as long as 30 years.  But since most mortgages are paid off when people move or refinance and do not last 30 years, mortgage rates tend to closely follow the 10-year Bond yield.  The 10-year Bond yield is determined in the open market and do not always move in lockstep with short-term rates.  Fixed mortgage rates do not follow the variable short-term the fed funds or discount rate.   Shorter term ARMs usually do, but not the 15 and 30 year mortgages.

Long-term rates are sensitive to expectations about inflation. If short-term rates like the ones the Fed controls are going up, this is usually an indication that the economy is growing, and the increase in short term rates can discourage borrowing and spending, which can actually cause inflation to decrease. Long-term rates, such as mortgage rates, often fall when concerns about inflation decrease, but long term rates rise when there are concerns about too much economic growth and inflation.
  
The short term rates the Fed controls, and the long term bonds that affect mortgage rates, have a basic opposing effect.
 
Basically, short term rates are increased on the basis to decrease economic growth and prevent inflation.
 
Once rates are increased enough to decrease spending, economic growth decreases, inflation risk decreases, and three things happen to decrease long term bond rates, and thus mortgage rates. 

1) Businesses: Higher interest rates make it more difficult for businesses to get loans to expand. Unemployment tends to rise, which eases wage inflation, although at a human cost.  Demand for capital decreases, lowering the interest rate through the laws of supply and demand.

2) Markets: Higher interest rates tend to attract investment into bonds and other fixed-income investments, pushing down stock prices.  Investors pull out of the stock market and push into the bond market to seek safer yields. This increases the price on the bond, thus lowering the rates.  If they see the Fed not acting aggressively enough, then they do the opposite, raising rates

3) Consumers: Higher interest rates on credit cards and mortgages can cool consumer spending, which accounts for about two-thirds of economic activity.  Since there is less risk of inflation in the future since economic growth is not occurring as fast, the bond yield can be lower since it is safer than the stock market, and there is no risk of inflation overwhelming this return. 
 
Since the bond and stock market and Real Estate make up the majority of wealth in our country, when inflation rises to much, spending reduces, and once again the cycle starts again.

Early the cycle of rate increases, it's hard to tell if the market will view the fed as acting too slow, or too aggressively.

So it is a constant battle for the Fed between fighting inflation and economic growth.  The Fed tries to balance the equation so long term rates and inflation is low, and the economy growing at a solid pace.

This is exactly what happened before the recent fed meeting about the fed funds rate. Mortgage rates actually rose because of inflation concerns. Housing financial markets often are ahead of the Fed. Mortgage interest rates are determined every day in active public markets. If those markets believe the economy is growing too fast and causing inflation, and the market is concerned that the Fed is not acting fast enough to raise rates and control inflation, interest rates may increase as the markets anticipate inflation.
  
It’s almost impossible to accurately predict the future of something as complex as the U.S. economy. However, it is important that mortgage consumers understand some of the market dynamics. A lack of understanding can cost them money.

 

As bond prices rise, the yield, or effective interest rate, drops.  If bond prices are going down  (which means the yield or interest rate is going up) that is generally a sign that higher mortgage rates are ahead. A weak bond market will usually (but not always) cause mortgage rates to rise. (see also Bond Prices and Bond yields)

 

Bond yields (rates) are usually high during a strong economy where there is inflation risk, and lower when there is little inflation risk. 

 

The bond yield had been on the rise for the last several months, as the bond market feels that the economy is in good shape and growing at a steady and possibly inflationary pace.  For today's announcement, rates were down slightly.

 

Many anticipate that long term mortgage rates will fall if the Fed's action spark a decline in the stock market by slowing the economy, which will cause money to flow out of stocks and into bonds.  This would cause bond yields to lower, which causes long term mortgage rates to go down.  Adjustable Rate Mortgage (ARM) rates will go up.

 

There is a bright side to this picture. The increase in short term rates is a sign the economy is in good shape, and the increases now will keep long-term rates lower over time by preventing inflation.  

 

Consumers might want to consider an interest only payment mortgage instead of a 30 year fixed - even some of these products have a 30 year fixed rate.  Or locking in a lower mortgage rate for three or five years could make sense because most people do not stay in a home more than five years, and those who do could refinance later.

 

What's next?  Depends on if the bond market feels the economy is better than the fed thinks it is - or if the fed is too slow to raise the short term rates again.  If the economy slows, bond rates will fall.  For now, bond rates and mortgage rates are moving higher, the question is how much and for how long?  

 

Rates will rise for home equity lines if the fed increases rates.  Those are based on prime, and if banks increase prime rate from 3.25% - home equity lines and second mortgage rates will be higher.  

Also, rates for people with challenged credit will slowly fall, as the economy is improving and this is lowering the risk in an economic growth cycle.

 

The overall result - rates are still very low - it's a great time to refinance or buy a home.

 

Want more information on exactly how the fed rates changes affect the economy?

Click here for more details on effects of rate increases.
Click here for more details on effects of rate decreases.

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