How the Federal Reserve Affects Mortgage Rates

When the Fed adjusts its target rate range, banks borrow from each other at different rates and use the resulting average overnight lending rate to set mortgage rates. If the Fed raises the rate range, lending becomes more expensive, and lenders will charge higher mortgage rates. Conversely, if the Fed lowers the rate range, lending becomes less expensive, and mortgage rates will drop.

Tools of Monetary Policy

The Federal Reserve uses monetary policy to meet its mandate to promote price stability and maximum employment. The Fed’s primary monetary policy tool is the target rate range, which guides other monetary policy tools such as its lending rate (discount window rate), interest it pays to banks on reserves, and open market operations.

Discount Window

The Fed’s discount window is where banks go to borrow as a last resort, such as when they can’t find another bank to borrow overnight from. The rate at the discount window helps the Fed set the ceiling on its target rate range, and is the highest rate a bank is charged for an overnight loan from the Fed.

Interest on Reserve Balances (IORB)

Banks used to be required to hold a percentage of deposits in reserves with the Fed, but this requirement ended when the central bank transitioned to its “ample reserves” regime. Banks can now choose to hold deposits in reserve and be paid interest. IORB allows banks to choose from receiving interest on their deposits or interest from lending, and is the Fed’s primary tool to keep overnight lending rates within its rate range.

Open Market Operations (OMO)

Open market operations are conducted 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, on May 4, 2022, the FOMC raised its federal funds rate target to a range of 0.75% to 1% and authorized the Federal Reserve Bank of New York to initiate open market operations to assist in maintaining the federal funds rate within that range.

Overnight Repurchase (ONRP) agreements are the Fed’s way of borrowing and lending from banks. The rates used in the repurchase facility help maintain the floor of the target rate range. For example, in its Implementation Note from May 4, 2022, the Fed announced 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 (ON RRP, 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.

Target Rate Range

The Fed sets its target rate range using the discount rate, IORB, and OMO (which includes ONRP and ON RRP). Banks are free to charge each other any rate within the target rate range, but because each option incentivizes them to consider how they would make the most money, their rates are generally very close. The Fed weighs and averages these rates and publishes the effective federal funds rate. This rate is also called the federal funds rate, and banks use it to set other interest rates.

The federal funds rate sets the floor for all other government and private debt interest rates. 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.

The Effect on Mortgage Rates

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 increase. 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, but the Fed initiated a short-term large-scale asset purchase program in 2020 as the COVID-19 pandemic struck.

In both instances, Fed securities purchases increased their price, lowering yields, at moments of credit market crisis. The Fed encouraged banks to fund mortgages at lower interest rates by purchasing 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.

Early 2022

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 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, preparing the market for a series of larger rate hikes and the start of a drawdown for Fed assets in the months ahead.

Mid-2022

By early May 2022, the 30-year fixed mortgage rate had risen to 5.30% 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.

Explain How the Fed Affects Mortage Rates Like I’m 5

The Federal Reserve sets a range of different interest rates at various facilities. The range and the rates included are designed to influence banks to borrow from and lend to each other. The rate (a weighted average) at which banks borrow and lend is then used by banks to set interest rates on all of their financial products—this rate is called the effective federal funds rate (but most still call it the federal funds rate).

Thus, the Federal Reserve’s monetary policy decisions indirectly affect mortgage interest rates.

The Bottom Line

The Fed aims to maintain economic stability, and its tools 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, its monetary policy actions typically result in a higher interest rate on mortgages.