The Fed does not directly control long-term interest rates including mortgage rates. However, approximately two-thirds of U.S. households own their own homes and most homeowners pay a mortgage. Mortgage interest rates therefore have a big impact on consumer behavior. The level of mortgage rates determines how much economic activity takes place in housing and hoe much homeowners have left to spend on additional consumption. How much people can spend on consumption, in turn, affects the overall economy.

Interest rates on home mortgages are important because mortgage interest is a major item in many people’s budgets. Even small changes in mortgage interest rates can have a large impact on how affordable it is to own a home. Homeownership has historically been a major means for many families to build wealth.

The Fed’s main tool is control over the short-term fed funds rate, which determines what banks charge each other for overnight loans. Fed actions influence not only the Fed Funds rate which in turn affects other short term rates, but this force now pressures the rise and fall of mid term and long term interest rates. Since the Fed Funds rate is on the very short end of the term structure of interest rates and mortgage rates are some of the longest terms, the influence the Fed has on mortgage rate is significant but distant.

Mortgage interest rates are largely influenced by other long-term interest rates or interest paying securities that mature in not less than five years. Supply and demand factors combined with the actual and perceived future level of inflation are the biggest contributors to long-term rates. Mortgages are a specific type of bond. Bond investors determine the interest rate they are willing to accept based on their perception of the future rate of inflation. Long-term mortgage rates are most closely tied to the activity in the 10-year Treasury yield, which is determined by these factors and the actions of bond traders worldwide.

Since the Fed takes action to influence short term rates to either stimulate economic activity or curtail inflation expectations, actions by the Fed will have an impact on the outlook for interest rates in the future. This outlook is not always a one to one correlation in the movement of the increase or decrease in Fed Funds rates. If the Fed should raise rates to prevent the acceleration of inflation, long term mortgage rates may actually drop in anticipation of lower inflation rates over the long term. In the opposite action, When the Fed cuts the Fed Funds rate, the intent is to lower borrowing costs for corporations so that they’ll invest and hire more and stimulate economic growth. But this economic growth can lead to inflation and long term mortgage rates may actually rise in anticipation of higher inflation rates. 30 year rates are largely effected by supply and demand of funds available for long term loans and the anticipated inflation rate.

Fed actions such as increasing the fed funds rate or decreasing the fed funds rate has the greatest impact on short-term mortgage instruments. or adjustable rate mortgages. There is more of a connection between Fed rate movements and short-term and adjustable rate mortgages. Adjustable rate mortgages are pegged to a number of different indexes, including the one-year Treasury yield and the international Libor, or London Interbank Offered Rate, which tend to move with the Fed funds rate. In fact, homeowners with ARM loans generally benefit the most from decreases in fed funds rates and suffer the most when the fed increases the fed funds rate.

For consumers, the increase in the fed funds rate can impact a variety of consumer loan products that are closely tied to short-term rates. Increases in the fed funds rate often leads to increases in other bank lending rates such as higher rates for credit cards, car loans and adjustable-rate mortgages.

There is not a significant correlation between moves in federal funds rate and 30 year mortgage rates that can be used for those looking to determine short term moves in the 30 year fixed mortgage rates. With the 2008 rate cut, the effect of the Fed cuts may entirely offset what would have been a significant rate reset for many homeowners. There will always be a significant economic impact of homeownership and the interest rates on mortgages associated with the vast majority of housing assets.

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