How will an increase in the federal funds target rate affect mortgage rates?

The Federal Open Market Committee (FOMC) of the Federal Reserve announced in June that it will maintain the current 0.00% to 0.25% target range for the federal funds rate, the recommended rate at which banks lend to each other. The Federal Reserve can control the rate by buying or selling government bonds, in an effort to maximize employment and control inflation. The economy has been operating in a low interest rate environment since the recession and many fear that a rise in the federal funds rate will have a negative impact on mortgage rates.

Mortgage rates are market driven by lenders competing to attract investors, not just the federal funds target rate. Although they are affected indirectly because of the impact on borrowing costs, mortgage rates are largely affected by the direction of the economy and yields on competing financial products, such as treasuries and bonds. Mortgage rates don’t increase simply because the target rate increases, although some economists are worried a rate increase will have a direct impact on mortgage rates in the current economic environment.

The Federal Reserve has not officially announced a date to raise the target rate, although 15 of the 17 FOMC members surveyed stated that they believe the hikes will begin before the end of 2015. Some economists have predicted that the first rate increase will be announced at the fed’s September meeting. However, Chair Janet Yellen ensured this week that rate increases will be gradual and that policy will remain accommodative, indicating the target rate will likely end the year between 0.5% and 0.75%. The committee’s median target rate estimate for 2016 is 1.625% and 2.875% for 2017.

Given today’s low interest environment, even small increases could have a large impact. The federal funds rate has remained below 1% for nearly seven years, while the average rate for Freddie Mac 30-year mortgages has remained below 6% during that time. Prior to the most recent recession that started in late 2007, the effective federal funds rate held steady at 5.3%, while mortgage rates averaged just over 6%. In the early 1980s, mortgage rates peaked at over 18% and the fed rate climbed over 19%.

The FOMC’s economic projections also play an important role in the direction of mortgage rates, since a strong economy usually means higher rates, while a weaker economy leads to lower rates. The committee’s June projections estimate that the economy will grow at a 1.8% to 2.0% pace during 2015, which was revised down from the 2.3% to 2.7% projection published during March. Growth for 2016 is projected at 2.4% to 2.7%.

The federal funds target rate plays an indirect role in the direction of mortgage rates, with the marketplace and other key indicators of the economy playing larger roles. Given the Federal Reserve’s statements regarding accommodating policy and that the economy has still not recovered to full strength, any increase in mortgage rates driven by an increase in the federal funds target rate are expected be gradual.