There is a lot of speculation in the news about when—or if—the Federal Reserve (“The Fed”) is going to “raise rates.” Many people about to buy a home or apply for a refinance mortgage are wondering, too. Is the Fed going to bump the rates in December?
With all the talk about The Fed, now would be a good time to explore some of what that mysterious organization does, and how it might affect mortgage rates—if at all.
Readers may already know that most loans are sold to investors. The names Fannie Mae, Freddie Mac and Ginnie Mae are probably familiar to most. We’ll refer to them as “GSEs,” for “Government Sponsored Enterprises.” Their primary function is to buy funded loans from lenders. In most cases, they’ll purchase these loans immediately after closing. They buy these loans by the thousands, then pool them into a type of bond called Mortgage Backed Securities (MBS). Investors buy and sell MBS every day, just as they buy stocks and other types of bonds.
When investors are more interested in buying than selling, the price increases. Conversely, when there are more sellers, the price goes down. This market activity, which goes on every business day, causes mortgage rates to fluctuate. Lenders look at the price of MBS when they compile their rates sheets each day because that will tell them the price they can get when they sell the loan they’re about to give you. When the price of the MBS goes up, the lender will get a higher price for your loan, so they give you a lower rate.
Investors decide to buy or sell MBS largely based on their fears of inflation. This is because MBS are a fixed-income investment, and inflation makes the dollar value of the MBS and the cash flow it generates worth less. Investors make an educated guess about inflation when they put their money into MBS. If they suddenly believe that inflation is going to be more than they had first expected, they’ll start to sell them. That will drive the prices down, and rates will go up.
The Federal Reserve, as the nation’s central bank, has the ability to speed up (stimulate) the economy or slow it down to avoid what they view as excessive inflation. They walk this fiscal tightrope by setting the Federal Funds Rate. This is the rate large banks use when they lend money to each other on a short-term basis. When the Fed chooses to lower the rate (as they have done since 2008), they are trying to stimulate the economy by reducing the cost of borrowing. When they believe the economy needs to grow faster, they’ll keep the Federal Funds Rate low. They’ll raise it proactively—usually .25% at a time—to keep inflation from getting too high.
By now, you may be wondering what any of this might have to do with the rate you can get on your mortgage. Be patient; we’re getting there.
Since the 2008 crisis, the Federal Reserve began using its nearly unlimited financial power to buy MBS directly. They call this process, “Quantitative Easing,” or “QE.” They began doing this in late 2008, when they bought $600 billion in MBS. This heavy buying caused the price of MBS to rise, and rates to fall. By March 2009, the Fed owned $1.75 trillion (with a “T”) in MBS. Today, the Fed owns roughly $4.5 trillion in MBS and similar securities.
You could say that the Fed influences mortgage rates directly by purchasing these unimaginably huge quantities of MBS, and you’d be right—but even with an essentially unlimited checkbook, they can’t keep buying. That’s where the Federal Funds Rate comes in.
The Fed has its foot on the economy’s metaphorical “accelerator.” By keeping the Federal Funds Rate low and by purchasing MBS directly, they are mashing down on the pedal, trying to get our massive economy up to speed. To keep it from going too fast—and producing too much inflation—they slow their purchasing of MBS and other bonds, and gradually raise the Federal Funds Rate.
The Fed has already increased the Federal Funds Rate twice in 2017. They may also increase once more this year. There is often a paradoxical effect at work when it comes to mortgage rates and the Fed. When they increase the Federal Funds Rate, mortgage rates are likely to stay where they are or even drop a little.
The reason for this paradoxical behavior is that the investors who buy fixed-income securities such as MBS always have inflation foremost in their minds. Some refer to it as the “I-Monster.” When the Fed acts to increase the Federal Funds rate, the investors often breathe a sigh of relief and hang onto their huge bond portfolios because they are confident that the Fed is paying attention and proactively keeping inflation at bay.
How do we know this? The Fed increased the Federal Funds rate by .25% on March 16 of this year. MBS had been selling off during the two weeks leading up to that decision, and rates marched nearly .50% higher. The day after the Fed’s announcement of the rate increase, MBS started a steady rally, and by April 18, rates had dropped by nearly .625%. The “I-Monster” was at bay. The second increase of the Federal Funds Rate happened on June 15. The market’s reaction was a gigantic, “ho-hum:” almost no reaction at all.
The best advice we can offer when you are thinking about getting a new mortgage, whether to buy or to refinance, is not to stress about what the Fed may or may not do. The market generally has a great deal of confidence in that institution in its control of inflation.