All good things must come to an end. That’s a common bit of folk wisdom, one that applies even to the Federal Reserve. There are now murmurs in the wind that the Fed is likely to revise its economic policies, an effort that could raise costs for real estate investors and mortgage borrowers generally.
How will this be done? By increasing bank rates and reducing the purchase of mortgage-backed securities (MBS).
Are higher mortgage rates a sure thing if the Fed acts? Maybe, but perhaps not as much as the Fed would like.
The Federal Funds Rate
The Fed is usually able to move bank rates up or down by changing the federal funds rate. The federal funds rate — the interest banks in the Federal Reserve system pay for overnight borrowing — is currently 0.08%. That’s a little tiny number, and surely a lot less than the 2.4% or so that banks were paying in 2019.
“The federal funds rate,” said Rick Sharga, Executive Vice President with RealtyTrac, “is set by the Federal Reserve and generally moves with the prime rate, a rate defined as the interest level banks charge their best customers. The prime rate started at 5.5% in 2019 and rapidly fell to 3.25% in 2020, where it is today.”
Sharga added that “mortgage rates more-or-less show a pattern that’s similar to the prime rate except in one important aspect: 30-year mortgage levels have often been below the prime rate during the past few years.”
The Fed wants to hold inflation to 2% or so, but according to Trading Economics, the monthly rate since May has been at 5% and above. The big debate is whether the higher monthly inflation figures are a short-term, transitory trend and thus not grounds for higher interest rates, or a long-term pattern that justifies a Fed push for higher rates.
A rate increase is likely to be deferred until 2022 as things now stand. The reason? The Covid-19 delta variant is causing havoc with the healthcare system, schools, unemployment levels, and supply chains. It’s simply too early, and too risky, to raise rates at this time.
If the federal funds rate moves higher, that would seem to guarantee rising interest levels, but mortgages may not move in lockstep.
The reason is that most mortgages bought by Ginnie Mae, Freddie Mac, and Fannie Mae — almost 72% in July according to the Urban Institute — were originated by nonbanks, lenders outside the Federal Reserve system. While nonbanks get some of their funds from commercial banks, they also tap other sources worldwide such as pension funds, insurance companies, and sovereign funds. In effect, they may be able to get money at a discount, which is passed through to borrowers to maintain origination volume.
Time To Taper?
To support mortgage lenders and the real estate market in general, the Fed is now buying $40 billion in mortgage-backed securities (MBS) a month.
“These MBS purchases,” explains Robert Dietz, chief economist with the National Association of Home Builders, “have held interest rates lower than they otherwise would have been.”
In its September meeting, the Fed’s Federal Open Market Committee (FOMC) said that continued MBS purchases are likely to end by mid-2022. Rather than a sudden halt to the program, the Fed will instead “taper” its purchases and make smaller and smaller MBS purchases each month.
If MBS purchases are holding down mortgage rates, and if the Fed expects to reduce those purchases, won’t that mean much higher rates?
It would sure seem that way, but again maybe not. The Fed must act with moderation. Here’s why.
First, trillions of dollars remain invested worldwide with negative interest rates. According to Bloomberg Businessweek, in May investors held $12 trillion in negative-yielding debt, down from $18 trillion in December but still a huge sum. That money is potentially available to the safe, secure, and positive US mortgage marketplace, money that can keep rates low.
Second, tapering will have less impact if loan volume declines. For instance, origination activity could fall significantly if rates rise, refinancing slows, or both. A smaller number of loan originations would mean fewer MBS to sell, MBS that were being bought by the Fed at the rate of $40 billion per month.
Third, we still have a pandemic and millions of people remain unvaccinated. The Fed’s usual strategies and expectations must be cautious until Covid-19 is no longer a threat to the economy. That’s not the situation today, and it’s unlikely to be the situation in early 2022. For this reason, and to avoid upsetting the economic gains to date, expect the Fed to act with moderation and with lots of notice in advance.