The Federal Funds rate, or Fed Funds, is the rate that banks can charge one another for overnight short term lending. The Federal Reserve Board of Governors hold the Federal Open Market Committee meetings around once every six weeks. At these two-day affairs, economic policy is discussed from various perspectives but one in particular is the cost of funds. The Fed can raise, lower or keep the Federal Funds rate the same, depending upon its view of the current economic climate as well as further down the road. But what the Fed doesn’t do is raise or lower interest rates on a standard, conventional 30 year fixed rate. Not directly, anyway.
How it Works
The Federal Funds rate, or Fed Funds, is the rate that banks can charge one another for overnight short term lending. How short term? Short term as in overnight. Why does a bank borrow money for such a short term? It has to do with its reserves. Banks are required by federal regulators to keep a certain amount of assets in cash or other liquid accounts. When bank customers want to withdraw money from their accounts, there needs to be money readily available, 24/7. If a particular bank sees their reserve requirements falling short, they borrow the funds from another bank. This is the rate the Fed controls and is in a range after this last cut of 2.00 to 2.25%. The increase yesterday was 0.25%. So far this year, there have been three such 0.25% increases with one more expected by the end of the calendar year. It was earlier this year the Fed did provide some guidance as to monetary policy when it predicted there would be four such moves in 2018 and so far they’re exactly on course.
Fed Funds Rate and The Economy
When the Fed raises or lowers the Fed Funds rate, it does so in an attempt to affect the economy. When the rate is increased, the theory is that consumers will borrow less and slow down spending. The ultimate affect is to keep a lid on inflation and so far they’re doing a pretty good job of that. The target inflation rate is in the neighborhood of 2.00%. The most recent inflation data comes from the August report which showed the inflation rate rose 2.20% when taking out food and energy prices. Food and energy tend to be more volatile in price. When including the two, the inflation rate as measured by the Consumer Price Index hit 2.70%. So far, these measured rate increases have not had any negative effect on the economy as right now the U.S. economy by most any measure is doing quite well.
Looking forward into the next year, economists see the GDP, or Gross Domestic Product, hit 2.50% which indicates a healthy economy without any fears of inflation. The Fed also indicated we could expect three more such rate increases next year. But if the Fed raises rates in 2018 a full percentage point and another 0.75% next year, will mortgage rates increase by the same amount?
No. The Fed adjusts the cost of funds banks charge one another but does not adjust the interest rate on someone’s mortgage. The Prime Rate is an exception, which closely follows the Fed Funds rate but in general, when the Fed raises rates yesterday by 0.25%, mortgage rates have remained relatively stable. This is because your 30 year fixed rate loan is tied to another index, such as the FNMA 30-yr 4.0 mortgage bond. Freddie Mac also issues its own bonds in various terms. It is these indexes that lenders follow when pricing rates each and every day.
A mortgage bond is just like any other bond or security. When an investor buys a bond, the outcome is known in advance. The investor doesn’t have to worry about the value of a bond. When investors review their portfolio, there will be a mix of investment types, primarily stocks and bonds. Stocks can, by nature, be more volatile as corporations report earnings each quarter but can provide greater returns. Bonds on the other hand provide relatively tame returns but the value of a bond is not how much someone can earn from owning it but the safety and security it provides. When investors feel the economy is starting to slow down, hitting at the value of their stock holdings, they can pull more money out of stocks and into the safety of bonds, including mortgage bonds. Conversely, if the outlook for the economy is a healthy one, more money flows out of bonds and into stocks. Greater demand for a bond will drive up the price of that bond, just like any other product or commodity. With bonds, when the price goes up, the yield- or returns- goes down. With a healthy economy and less demand for bonds, the price falls and rates rise.
So why do mortgage lenders pay so much attention to what the Fed does or doesn’t do with the Fed Funds rate? It’s an insight as to what the Board of Governors thinks the economy is headed. At the end of these two-day FOMC meetings, the Fed makes an announcement regarding what they discussed, their outlook on the economy and if they did anything with the Fed Funds rate. Their statements at the most recent meeting certainly indicate the economy is in fine shape and at the same time, inflation is not on the horizon. This is pretty good news. But again, your rate is not directly tied to what the Fed does or doesn’t do. Instead, it’s an indicator of where the economy is headed.
That said, mortgage rates have been on a gradual increase and look to continue that trend into next year. If you’re thinking of refinancing your mortgage, it’s probably a good idea to go ahead and lock in these current rates. And, if you’re in the market for a home any increase in rates means higher payments. Not by a lot, but higher nonetheless.