How the Fed Affects (and Doesn’t Affect) Mortgage Rates

When it comes to the Federal Reserve, aka “The Fed” and mortgage interest rates, appearances can be deceiving. That’s probably because every time the Federal Open Market Committee (FOMC) has a meeting, the media are likely to report something like, “The Fed voted today to keep interest rates low,” or, “The Fed indicated that it will not move to raise interest rates until US unemployment reaches 6.5 percent,” which is pretty much what Fed Chairman Ben Bernanke said after the meeting in June 2013.

However, the Fed doesn’t “raise” and “lower” mortgage rates, even if reporters make it sound as though it does. Here’s what’s really happening when the Fed votes to influence interest rates, and what happens to make mortgage rates move up or down.

How the Fed Works

The Federal Reserve gets its name from its role as the custodian of reserve funds for depository institutions in the US. These depository institutions are required by law to maintain a certain level of deposits, called reserves, with the Federal Reserve Bank, so that there will be money to pay depositors when they want it. The Fed allows institutions to lend reserves out to each other overnight to cover fluctuating needs for cash. The rate that is charged for these loans is called the Federal Funds Rate. It’s this rate that the Fed targets when it “changes” interest rates.

Changes in the Federal Funds rate promote changes in the Prime Rate, which is what lending institutions charge their best customers. Many kinds of loans, like credit cards, business lines of credit and construction lending are tied to the Prime Rate.

When the Federal Open Market Committee votes to raise or lower the Fed Funds Rate, what it's really doing is voting to cool down or heat up the US economy. Raising the rate slows down economic activity by making borrowing more expensive, while lowering it heats the economy up by making borrowing cheaper.

How Mortgage Rates Work

The Federal Reserve has no authority to set mortgage rates, however. Zip. Nada. Bupkis.

You can see from historical data that the Fed Funds Rate is pretty disconnected from U.S. mortgage rates.

Average Mortgage Rate 30-year

Between 200 and 2013, the spread between the Fed Funds Rate and the average 30-year fixed rate mortgage (per Freddie Mac) rate has ranged from .50 percent to 5.25 percent!

Mortgage rates are really set by investors worldwide. Most mortgages are sold to investors, bundled up into mortgage bonds, or MBS. When there is a high demand for these securities, their prices go up, and mortgage rates come down. When demand for MBS drops, prices go down, and mortgage interest rates go up. Most of the time, demand goes up when the economy is shaky and it goes down when the economy heats up.

And that’s how the Fed can influence mortgage rates with its words. When the Fed releases a statement, investors everywhere try to decode the message – if the Fed appears to be pessimistic about the economy, investors may flee the stock market and park their money in the MBS market. When demand for bonds increases, their prices go up, and their yields (mortgage interest rates) go down. Conversely, when the Fed seems to be optimistic about the economy, demand for bonds goes down, their prices go down, and mortgage interest rates go up.

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