The Relationship Between Federal Funds Rate and Mortgage Interest Rate

News hit this week that the Federal funds rate was adjusted to 0%…. But what does that mean, actually??

What is the federal funds rate?

The federal funds rate is the interest rate banks charge each other for overnight loans to meet reserve requirements. If a bank can’t meet its reserve requirements, it can borrow money from the Federal Reserve or from other banks that hold funds at the Fed. This is separate from the discount rate, the rate that the Fed charges for overnight loans.

Deeper definition

The Federal Reserve requires banks and other financial institutions to hold a certain amount of money in reserves at the end of each business day to ensure customers can access their funds and to protect against bank failures. This is referred to as the reserve requirement. The reserve requirement is approximately 10 percent of the deposits made at a financial institution. For example, if a bank has deposits of $100,000,000, the bank’s overnight reserve requirement would be roughly $10,000,000.

Banks frequently hold their reserve requirements at the Federal Reserve. Money that is held at the Federal Reserve is referred to as federal funds. The federal funds target rate is the interest rate set by the Fed’s monetary policymaking body, the Federal Reserve Open Market Committee (FOMC), at its eight annual policy meetings. The federal funds effective rate is the actual rate of interest banks charge each other for loans to meet reserve requirements.

The Fed has a few different methods for influencing the federal funds rate. Most commonly, the Fed engages in open market operations by purchasing or selling government bonds and other securities. This increases or decreases the amount of money that circulates in the U.S. economy. It also helps manage the federal funds effective rate.

The Fed can raise or lower the discount rate to influence the federal funds effective rate. For example, if the economy needs to be stimulated, it may lower the discount rate. If banks can borrow money from the Fed at a lower rate, this encourages them to lower the rates offered to their customers.

Lastly, the Fed can adjust banks’ reserve requirements. Increasing or reducing the amount of money banks are required to hold in reserves increases or reduces the amount of money they have to lend.

In a nutshell, the federal funds rate is a tool that the Federal Government uses to stimulate or tighten the economy–it does not directly impact the mortgage rate market. The factors that come into play are still economic-based: inflation, stock market fluctuations, and of course global news.

The elephant in the room is the Covid 19 Virus and its impact on the national and global economy. Once we see what direction this goes we will all have more clarity on how quickly we will bounce back to a more normal mortgage market with less volatility in movement of long term mortgage rates.

The Fed Funds rate has been to zero as recently as just a few years ago to help dig out of the mortgage meltdown, so this is actually not uncharted territory. (Some news articles suggest that this is the “lowest it has ever been”)

Mortgage rates are hovering in the 3.25% to 3.75% range currently; with experts believing this will be a short term blip on the economic radar.