Navigating Mortgage Interest Rate Volatility: The Federal Reserve's Impact and What Homebuyers Need to Know
Mortgage interest rates have been subject to volatility in recent times, leaving many homebuyers and those interested in refinancing their homes unsure about what to do. Understanding how the Federal Reserve (Fed) impacts mortgage interest rates is crucial to gaining insight into why rates fluctuate.
Federal Funds Effective Rate
This is the rate the Fed controls. Not the mortgage interest rate.
The Fed primarily impacts mortgage interest rates through two methods: the Federal Funds rate and buying and selling mortgage-backed securities (MBS). The Federal Funds rate is the rate at which banks borrow from each other, and it sets the tone for all other interest rates in the economy, including mortgage rates. The Fed buys and sells MBS, which are essentially bundles of mortgages that investors can purchase. By doing so, the Fed can influence demand and supply for these securities, which, in turn, impacts mortgage rates.
The Increase of Mortgage-Backed Securities Held by the US Federal Reserve
Since the Great Recession the Fed started buying up Mortgage-Backed securities. This had an effect to stimulate/increase demand for mortgages, and lowered mortgage interest rates.
The Chart below is in MILLIONS of U.S. Dollars.
The Fed reached localized maximum levels around:
2011: ~$1.2 Trillion in MBS holdings
2015 - 2018: ~$1.65 Trillion in MBS holdings
2022: ~$2.78 Trillion in MBS holdings
For comparison, the entire US economy is currently estimated at ~$26.8 Trillion. The 2022 peak MBS holdings were more than 10% (1/10) of the entire US economy!
It's worth noting that the average 30-year mortgage interest rate (as measured by Freddie Mac and others) may not go below 4% ever again, possibly not even 5%, given that the 30-year rate never went below 5% before the great recession. During the 2000s, there was too much demand for housing due to mortgage loans being too easy to get, and subprime mortgage loans were prevalent. These included "NINJA" loans (no income, no job, no assets verification required to get the loans). As a result, there was a lot of default because of too many unqualified or underqualified people getting approved, in addition to the "normal amount of people" having life or work changes that cause mortgage defaults on average over time. The housing supply in the 2000s was also too high, leading to a crash during the great recession.
30-year fixed rate mortgage average in the USA
Data measured by Freddie Mac. These are average prime offered rate, which is the average of “prime” mortgage rates (e.g., best mortgage rates offered) not an average of all rates quoted or given at close for all borrowers at any given time.
The Fed held very little to no mortgage-backed securities before the great recession and bought steadily over the ensuing years. There was an attempt to sell off some of the MBS in the mid-2010s, but politics and the COVID-19 recession pushed a tremendous amount of money supply into the market, including massive purchases by the Fed. Since then, the Fed has been selling off tens of billions of dollars of MBS, which has affected mortgage rates.
A closer look at MBS holdings by the Fed: 2020 on
The Fed nearly DOUBLED its holdings of Mortgage-Backed Securities from ~$1.4 in April 2020 to almost $2.8 Trillion of MBS in early 2022. This drastic increase in MBS holdings is unprecedented. It was a major driver in decreasing mortgage interest rates.
The Fed has been consistently selling of MBS since that time.
However, there is tremendous day-to-day uncertainty regarding where mortgage rates will be, as even positive economic indicators that would typically increase MBS demand for lower coupons and decrease mortgage interest rates may not have an impact. This is because the Fed could still decide to sell such a large amount of MBS that they could single-handedly keep interest rates high for some time, even if all other indicators push mortgage interest rates down.
It's essential to understand the relationship between mortgage interest rates and inflation. While we still have inflation well above 2%, the latest Consumer Price Index (CPI) and Personal Consumption Expenditures (PCE) reports state that inflation was at 6.2% and 4.7%, respectively, year-over-year. We have some way to go with that indicator alone before we can see the best-possible mortgage rates in that regard alone, much less when we take all other indicators into account. Therefore, it should be no surprise that mortgage interest rates are as high as they currently are and will stay high for some time.
Measurement of Inflation since 2018: Personal Consumption Expenditures (PCE)
In conclusion, understanding how the Fed impacts mortgage interest rates, along with inflation and other indicators, is essential to knowing what's going on with mortgage interest rate volatility. While there is no certainty as to where rates will be in the short term, keeping an eye on these factors will help guide homebuyers and those interested in refinancing their homes.