Does The Fed Control Mortgage Rates?

One of the biggest misconceptions in finance is that the Federal Reserve “sets” mortgage rates.

While “the Fed” can use levers to influence mortgage rates, it doesn’t directly control them.

Market forces form mortgage rates; the Fed no more controls rates than it does the stock market.

Here’s what actually drives rates and how the Fed affects them.

How Does the Fed Influence Mortgage Rates?

The Federal Open Market Committee, or FOMC is the 12-member group within the Federal Reserve that is tasked to meet certain economic goals.

One of those goals is to keep inflation in check. Another is to achieve maximum employment.

When the economy is too hot, inflation rises. The Fed raises the federal funds rate, thereby pushing up many types of interest rates – those for business loans, credit cards, and mortgages. Higher rates discourage hiring, buying, and borrowing, cooling the economy.

When the economy is sluggish and unemployment rises, it lowers the federal funds rate. This encourages borrowing, investing, and hiring via access to “easy money” as some would put it.

The Fed does set the federal funds rate, but this rate only has an indirect influence on mortgage rates, as shown in the following chart.

So What Controls Mortgage Rates?

Mortgage rates are determined by market demand for mortgage-backed bonds. These are called mortgage-backed securities or MBS.

Investors buy mortgage bonds to earn interest just like they might buy a stock to earn dividends or a higher price in the future.

Many believe mortgage rates exactly follow the 10-year Treasury yield. While mortgage rates follow the 10-year Treasury more closely than the fed funds rate, the relationship is far from perfect.

Currently, mortgage rates seem to have become almost unhinged from the 10-year with massive spreads between these two rates.

In 2010, the 30-year mortgage rate was just 1.2% above the 10-year Treasury. In August 2023, the spread rose to 3.02%.

This proves that market investors, not the 10-year Treasury, have the final say about mortgage rate levels.

Quantitative Easing: The Closest the Fed Gets to Controlling Mortgage Rates

The Fed has another lever for mortgage rates specifically: it can buy mortgage-backed bonds on the open market.

During recessions, the Fed becomes a massive buyer of mortgage bonds. This increases demand, driving down rates. (High demand means investors will buy the asset even at a very low rate of return.)

This Fed lever is very effective at reducing consumer mortgage rates.

In the following graph, notice mortgage rate drops around the time of "Quantitative Easing" or "QE", the Fed's name for adding assets to its portfolio. The blue line indicates asset buying by the Fed. The most prominent examples of QE are in late-2008 and early 2020.

Image: Fed holdings of mortgage-backed securities (blue line) versus mortgage rates (red line).

By driving down rates, the Fed encourages homebuying – a major driver of the economy. Plus, it induces refinancing, lowering housing costs for homeowners and increasing disposable income that they can spend in the economy.

Despite its massive influence, the Fed could never say “mortgage rates will be 4%.” This is entirely up to the market.

Does the Fed Control Any Type of Home Loan Rate?

While “control” is a strong word, the Fed does have more of a direct impact on home equity lines of credit (HELOCs).

The prime rate is typically 3% above the federal funds rate. HELOC rates are based on prime.

For example, you might get a HELOC at prime plus one. If the fed funds rate were 5%, prime rate would be 8% and your HELOC rate would be 9%.

When the Fed changes its federal funds rate, the prime rate changes and therefore so do HELOC rates.

This isn't the same relationship the fed funds rate has to primary first mortgages, however.

How Should You Plan Homebuying or Refinancing Based on Fed Action?

When it comes to the Fed, expectation is more powerful than reality.

For example, Fed projections from its December 2023 meeting indicated lower federal funds rates in 2024. This sent mortgage rates falling three to six months before the potential rate cuts in March or June.

As a mortgage shopper, watch for unexpected good news from the Fed and from various economic reports. Often, you can capture a low rate before market euphoria of interest-rate-friendly news wears off.

Be in close contact with your loan officer and set up online alerts for dropping rates. Apply for the refinance, or get pre-approved and find a home so you’re ready.

Leverage market forces in your favor. You’ll be waiting forever if you're counting on the Fed to “set mortgage rates.”