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Primer on the Federal Reserve and Mortgage Rates

By Rob Chrisman, Senior Advisor

We’ve all seen recent reports about inflation and certainly felt its effects. In discussions with STRATMOR clients, everyone is being hit by higher rates, caused in part by inflation, and these higher rates are directly responsible for a drop in lock and production volumes and lower margins as lenders try to hang on to their market share. At the “top of the funnel,” inflation feels good if you’re a homeowner and similar homes around you sell for much higher prices than you paid. You feel wealthier, and you could tap big equity at cheap rates! But if you’re hoping to buy a home, it doesn’t feel so great. Bidding wars create a scary upward spiral for aspiring buyers.

But what is happening out there to lenders and their potential clients?

Throughout much of 2021 Federal Reserve (“Fed”) officials told us that general inflation was transitory and blamed the supply chain, whether it was a ship stuck in the Suez Canal or chip shortages. But because inflation has not been transitory, and has been steadily increasing, the Federal Reserve Bank has announced not only expected target fed funds rate increases throughout 2022 and the ceasing of buying fixed-income securities, but also the added measure of the sale of its balance sheet holdings to drive down prices of fixed-income securities and thus drive up yields. When yields/rates go up, people and companies are less inclined to spend money. A house that makes sense at three percent may not make sense at six percent; building a new distribution center by borrowing money at three percent may not make sense at six percent.

Looking at mortgage rates themselves, lenders should know that the two major factors influencing rates at this point are inflation and Russia’s war against Ukraine. Inflation, at multi-decade highs, is a big focus of the Federal Reserve. At its current levels, inflation at the consumer and producer price levels is causing instability, something the Federal Reserve does its best to combat. And Russia’s war, in addition to causing a terrible loss of life is causing economic instability around the world, something that every central bank in each country is trying to fight.

Increasing short-term interest rates, or the rate the member banks of the federal reserve system charge each other to borrow money, increases costs to consumers because they pass it along. They have to charge their customers more than they pay for money to make a profit. Long-term interest rates, such as home mortgages, are a different story. Although the Fed doesn’t control mortgage rates, it manipulates them by buying government bonds and mortgage-backed securities. Lenders need to help borrowers understand that the “Overnight” federal fund rate — the interest commercial banks charge when they lend money to one another for extremely short-term periods, literally, overnight— is not the same as “the 30-year mortgage” rate offered them.

Inflation and a growing economy, which are pushing the Fed to act, also lead to higher mortgage rates. Federal Reserve Chairman Jerome Powell stated, “This is going to be a year in which we move steadily away from the very highly accommodative monetary policy that we put in place to deal with the economic effects of the pandemic. I would say that the committee is of a mind to raise the federal funds rate at their next several meetings, assuming conditions are appropriate for doing so. I don’t think it’s possible to say exactly how this is going to go, and we’re going to need to be, as I’ve mentioned, nimble about this so that we can respond to the full range of plausible outcomes.”

According to the U.S. Bureau of Labor Statistics, inflation measured by the Consumer Price Index and the Producer Price Index is running at 8-10 percent per year. This is far above the Fed’s stated target of two to three percent. The rates market is now pricing in 13 hikes for the cycle, with a terminal rate of 3.25 percent for overnight Fed funds. But if the economy continues to “climb the wall of worry,” as it has to date, the Fed might have to get even more aggressive, and rates will have to rise further. Powell also said that the Fed’s focus has always been on the underlying economy, and a byproduct of that has been inflated asset prices. But now that inflation is here and real while labor markets have slack, it’s time to focus on that. Mortgage rates, which have suffered, are expected to continue to rise.

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